[Federal Register Volume 86, Number 3 (Wednesday, January 6, 2021)]
[Rules and Regulations]
[Pages 810-863]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-28653]
[[Page 809]]
Vol. 86
Wednesday,
No. 3
January 6, 2021
Part IV
Department of the Treasury
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Internal Revenue Service
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26 CFR Part 1
Taxable Year of Income Inclusion Under an Accrual Method of Accounting
and Advance Payments for Goods, Services, and Other Items; Final Rule
Federal Register / Vol. 86 , No. 3 / Wednesday, January 6, 2021 /
Rules and Regulations
[[Page 810]]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 9941]
RIN 1545-BO68 and 1545-BO78
Taxable Year of Income Inclusion Under an Accrual Method of
Accounting and Advance Payments for Goods, Services, and Other Items
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations regarding the timing
of income inclusion under an accrual method of accounting, including
the treatment of advance payments for goods, services, and certain
other items. The regulations reflect changes made by the Tax Cuts and
Jobs Act and affect taxpayers that use an accrual method of accounting
and have an applicable financial statement. These final regulations
also affect taxpayers that use an accrual method of accounting and
receive advance payments.
DATES:
Effective Date: The regulations are effective on December 30, 2021.
Applicability Dates: For dates of applicability, see Sec. Sec.
1.451-3(m), 1.451-8(h), and 1.1275-2(l)(2).
FOR FURTHER INFORMATION CONTACT: Concerning any provisions in Sec.
1.451-3 within the jurisdiction of the Associate Chief Counsel (Income
Tax & Accounting), Jo Lynn Ricks, (202) 317-4615, Sean Dwyer, (202)
317-4853, or Doug Kim, (202) 317-4794, and concerning any provisions in
Sec. 1.451-8 within the jurisdiction of the Associate Chief Counsel
(Income Tax & Accounting), Jo Lynn Ricks, (202) 317-4615, or David
Christensen, (202) 317-4861; concerning any provisions in Sec. 1.451-3
or Sec. 1.451-8 within the jurisdiction of the Associate Chief Counsel
(Financial Institutions & Products), Deepan Patel, (202) 317-3423, or
Charles Culmer, (202) 317-4528 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
This document contains amendments to the Income Tax Regulations (26
CFR part 1) under section 451(b) and (c) of the Internal Revenue Code
(Code).
On December 22, 2017, section 451(b) and (c) were amended by
section 13221 of Public Law 115-97 (131 Stat. 2054), commonly referred
to as the Tax Cuts and Jobs Act (TCJA). Section 451(b) was amended to
provide that, for a taxpayer using an accrual method of accounting
(accrual method taxpayer), the all events test for an item of gross
income, or portion thereof, is met no later than when the item, or
portion thereof, is included in revenue for financial accounting
purposes on an applicable financial statement (AFS). Section 451(c) was
amended to provide that an accrual method taxpayer may use the deferral
method of accounting provided in section 451(c) for advance payments.
Unless otherwise indicated, all references to section 451(b) and
section 451(c) hereinafter are references to section 451(b) and section
451(c), as amended by the TCJA.
I. Section 451(b)
In general, section 451(a) provides that the amount of any item of
gross income is included in gross income for the taxable year in which
it is received by the taxpayer, unless, under the method of accounting
used in computing taxable income, the amount is to be properly
accounted for as of a different period. Under Sec. 1.451-1(a), accrual
method taxpayers generally include items of income in gross income in
the taxable year when all the events occur that fix the right to
receive the income and the amount of the income can be determined with
reasonable accuracy (all events test). All the events that fix the
right to receive income occur when (1) the required performance takes
place, (2) payment is due, or (3) payment is made, whichever happens
first. Revenue Ruling 2003-10, 2003-1 C.B. 288; Revenue Ruling 84-31,
1984-1 C.B. 127; Revenue Ruling 80-308, 1980-2 C.B. 162.
Section 451(b)(1)(A) provides that, for an accrual method taxpayer,
the all events test for an item of gross income, or portion thereof, is
met no later than when the item, or portion thereof, is included as
revenue in an AFS (AFS Income Inclusion Rule).
Section 451(b)(1)(B) lists exceptions to the AFS Income Inclusion
Rule. The AFS Income Inclusion Rule does not apply to taxpayers that do
not have an AFS for a taxable year or to any item of gross income from
a mortgage servicing contract.
Section 451(b)(1)(C) codifies the all events test, stating that the
all events test is met for any item of gross income if all the events
have occurred which fix the right to receive such income and the amount
of such income can be determined with reasonable accuracy.
Section 451(b)(2) provides that the AFS Income Inclusion Rule does
not apply for any item of gross income the recognition of which is
determined using a special method of accounting, ``other than any
provision of part V of subchapter P (except as provided in clause (ii)
of paragraph (1)(B)).''
Section 451(b)(3) defines an AFS, as referenced in section
451(b)(1)(A)(i), by providing a hierarchical list of financial
statements.
Section 451(b)(4) provides that for purposes of section 451(b), in
the case of a contract which contains multiple performance obligations,
the allocation of the transaction price to each performance obligation
is equal to the amount allocated to each performance obligation for
purposes of including such item in revenue in the taxpayer's AFS.
Section 451(b)(5) provides that, if the financial results of a
taxpayer are reported on the AFS for a group of entities, the group's
financial statement shall be treated as the AFS of the taxpayer.
II. Section 451(c)
Section 451(c) provides special rules for the treatment of advance
payments. Section 451(c)(1)(A) provides the general rule requiring an
accrual method taxpayer to include an advance payment in gross income
in the taxable year of receipt. However, section 451(c)(1)(B) permits a
taxpayer to elect to include any portion of the advance payment in
gross income in the taxable year following the year of receipt to the
extent income is not included in revenue in the AFS in the year of
receipt. Section 451(c)(1)(B) generally codifies Revenue Procedure
2004-34, 2004-22 I.R.B. 991, which provided for a similar deferral
period.
Section 451(c)(2)(A) provides the Secretary of the Treasury or his
delegate (Secretary) with the authority to provide the time, form and
manner for making the election under section 451(c)(1)(B), and the
categories of advance payments for which an election can be made. Under
section 451(c)(2)(B), the election is effective for the taxable year
that it is first made and for all subsequent taxable years, unless the
taxpayer receives the consent of the Secretary to revoke the election.
Section 451(c)(3) provides that the deferral election does not apply to
advance payments received in the taxable year that the taxpayer ceases
to exist.
Section 451(c)(4)(A) defines advance payment for purposes of
section 451(c). Under section 451(c)(4)(A), the term advance payment
means any payment that meets the following three requirements: (1) The
full inclusion of the payment in gross income in the year of receipt is
a permissible method of accounting; (2) any portion of the
[[Page 811]]
advance payment is included in revenue in an AFS for a subsequent tax
year; and (3) the advance payment is for goods, services, or such other
items that the Secretary has identified. Section 451(c)(4)(B) lists
certain payments that are excluded from the definition of advance
payment and gives the Secretary the authority to identify other
payments to be excluded from the definition. Section 451(c)(4)(C)
provides a special definition of the term ``receipt'' for purposes of
the definition of advance payment, and section 451(c)(4)(D) states that
rules similar to those for allocating the transaction price among
performance obligations in section 451(b)(4) also apply for purposes of
section 451(c).
III. Prior Guidance
On April 12, 2018, the Department of the Treasury (Treasury
Department) and the IRS issued Notice 2018-35, 2018-18 I.R.B. 520,
providing interim guidance on the treatment of advance payments and
requesting suggestions for future guidance under section 451(b) and
section 451(c). On September 27, 2018, the Treasury Department and the
IRS issued Notice 2018-80, 2018-42 I.R.B. 609, announcing that the
Treasury Department and the IRS intend to issue proposed regulations
providing that accrued market discount is not includible in income
under section 451(b).
On September 9, 2019, the Treasury Department and the IRS published
proposed regulations under section 451(b) (REG-104870-18, 84 FR 47191)
(proposed section 451(b) regulations) and proposed regulations under
section 451(c) (REG-104554-18, 84 FR 47175) (proposed section 451(c)
regulations), referred to collectively hereinafter as the ``proposed
regulations.'' The notices of proposed rulemaking for section 451(b)
and (c) reflect consideration of the comments received in response to
Notice 2018-35.
A public hearing on the proposed regulations was held on December
10, 2019, at which two speakers provided testimony. The Treasury
Department and the IRS received approximately ten written comments
responding to the proposed regulations.
After the comment period for the proposed regulations closed, the
Treasury Department and the IRS received a comment letter regarding the
allocation of transaction price for contracts that include both income
subject to section 451 and income subject to a special method of
accounting provision, specifically, section 460. In response to these
comments, in the Explanation of Provisions of a notice of proposed
rulemaking (REG-132766-18) that was published on August 5, 2020 (85 FR
47508), the Treasury Department and the IRS suggested allocation rules
and requested comments regarding the application of section 451(b)(2)
and (4) to contracts with income that is accounted for in part under
proposed Sec. 1.451-3 and in part under a special method of
accounting. No formal comments were received regarding these suggested
rules.
Comments received before these regulations were substantially
developed, including all comments received on or before the deadline
for comments on November 8, 2019, were carefully considered in
developing these regulations. Copies of the comments received are
available for public inspection at http://www.regulations.gov or upon
request. After consideration of the comments received and the testimony
at the public hearing, this Treasury decision adopts the proposed
regulations as revised in response to such comments and testimony. The
comments and the revisions are discussed in the Summary of Comments and
Explanation of Revisions section of this preamble.
Summary of Comments and Explanation of Revisions
I. Overview
This Summary of Comments and Explanation of Revisions section
summarizes the formal written comments and some of the informal
commentary, both in writing and at public events, addressing the
proposed regulations. Comments merely summarizing or interpreting the
proposed regulations or recommending statutory revisions generally are
not discussed in this preamble. Similarly, comments outside the scope
of this rulemaking generally are not addressed in this Summary of
Comments and Explanation of Revisions section.
II. Comments and Explanation of Revisions Regarding the Proposed
Section 451(b) Regulations
A. Realization and Recognition
As noted in the preamble to the proposed section 451(b)
regulations, footnote 872 of the Conference Report to the TCJA states
that section 451(b) was not intended to revise the rules associated
with when an item is realized for Federal income tax purposes and does
not require the recognition of income in situations where the Federal
income tax realization event has not taken place. See H.R. Rep. No.
115-466, at 428 fn. 872 (2017) (Conf. Rep.). As also noted in the
preamble to the proposed section 451(b) regulations, footnote 874 of
the Conference Report provides, by way of example, that the timing
rules of section 451(b) apply to unbilled receivables for partially
performed services. Id. at 428 fn. 874.
Commenters provided little commentary on footnote 874, except to
state that it is contrary to footnote 872. Instead, the commenters
presented two views. First, some commenters highlighted footnote 872
and cited case law to support the claim that a realization event is,
and has always been, a prerequisite for income recognition. These
commenters acknowledged, however, that the case law frames the issue
not in terms of ``realization'' but rather in terms of whether a seller
has a fixed right to income under the all events test.
Second, some commenters suggested definitions of realization.
However, these recommended definitions differ, particularly as to
whether realization applies to the provision of services. For example,
some commenters described realization as applying to both contracts for
the provision of services and contracts for the sale of goods, and
stated that realization occurs when the taxpayer has a ``fixed and
unconditional right to payment'' under the contract. One commenter
reasoned that existing judicial precedents require realization without
distinguishing between whether the income is for the performance of
services or the sale of property. Another commenter asserted that
realization means there has been a sale or disposition under section
1001(a), suggesting that realization applies only to the sale of
property. In sum, these commenters suggested that the proposed section
451(b) regulations do not give effect to footnote 872 in the Conference
Report and ask that the final regulations either explicitly define
realization or clarify when realization occurs in certain
circumstances, such as where a taxpayer produces goods for customers or
where a taxpayer provides non-severable services to customers.
The Treasury Department and the IRS have considered these comments
and decline to define the term realization in the final regulations.
Congress did not explicitly define realization in the Conference
Report. Some of the suggested definitions of realization, particularly
the ones equating realization with the all events test, would nullify
the AFS Income Inclusion Rule entirely, which is clearly contrary to
Congress' intent. Accordingly, it is reasonable to conclude that
Congress intended a different concept of realization that would give
full effect to
[[Page 812]]
the statute. Further, the final regulations do not clarify when
realization occurs in specific circumstances. Realization is a factual
determination that, while closely aligned with the all events test, has
different meanings in different contexts.
Section 451 is a timing provision and the amendments to section
451(b)(1)(A) by TCJA were intended to modify the timing of income to
require an accrual method taxpayer with an AFS to treat the right to
income as fixed, under the all events test, no later than the time at
which the item (or portion thereof) is taken into account in its AFS.
The statute thus reflects Congress' intent to incorporate timing
concepts from the financial reporting rules in the tax timing rules for
including items in gross income. It does not seek to answer whether the
AFS income inclusion has been realized. Accordingly, the focus of the
final regulations is on the appropriate taxable year of AFS income
inclusion.
B. Scope of AFS Income Inclusion Rule
1. Proposed Sec. 1.451-3(b): General Rule
The general AFS Income Inclusion Rule in the proposed section
451(b) regulations provides that, if a taxpayer includes an item of
gross income, or portion thereof, in revenue in the taxpayer's AFS, the
taxpayer must include the item in gross income under section 451(b). In
addition to commenting that the general rule in the proposed section
451(b) regulations potentially overrides the realization requirement,
contrary to footnote 872 of the Conference Report, commenters suggested
that the rule is overbroad and could cause taxpayers to incur a tax
liability without having the money to pay the liability.
The Treasury Department and the IRS note that the potential to
incur a tax liability without having the money to pay the liability is
inherent in the accrual method. However, the Treasury Department and
the IRS acknowledge that the proposed AFS Income Inclusion Rule could
exacerbate this situation and that the proposed rule could result in
inclusions that would be inconsistent with footnote 872 of the
Conference Report. Accordingly, the final regulations provide that,
under the AFS Income Inclusion Rule, the all events test under Sec.
1.451-1(a) for any item of gross income, or portion thereof, is met no
later than when that item, or portion thereof, is ``taken into account
as AFS revenue.'' In determining when an item of gross income is
``taken into account as AFS revenue,'' AFS revenue is reduced by
amounts that the taxpayer does not have an enforceable right to recover
if the customer were to terminate the contract on the last day of the
taxable year. The determination of whether the taxpayer has an
enforceable right to recover amounts of AFS revenue is governed by the
terms of the contract and applicable Federal, state, or international
law, and includes amounts recoverable in equity and liquidated damages.
The revised rule is designed to reconcile the intended preservation
of the realization concept, consistent with footnote 872 of the
Conference Report, with the intended scope of section 451(b), as
illustrated in footnote 874 of the Conference Report. The revised rule
is also consistent with concepts illustrated in Example 4 in the Joint
Committee on Taxation, General Explanation of Public Law 115-97 (JCS-1-
18) at 163 (Dec. 20, 2018) (Blue Book). In the example, the taxpayer
enters into a contract with a customer for a customized piece of
machinery. Under the contract, the taxpayer will not invoice the
customer until the item is delivered to the customer, the customer
accepts the machinery, and title to the machinery has transferred to
the customer. The contract specifically provides that, if the customer
withdraws from the agreement, the taxpayer has an enforceable right to
payment as the work is performed, even if the contract is not
completed. The taxpayer does not complete the machinery in year one but
includes an amount in revenue in its AFS in year one. Example 4
concludes that, under the AFS Income Inclusion Rule, the taxpayer is
required to recognize the amount in year one. The revised AFS Income
Inclusion Rule in the final regulations incorporates the key elements
reflected in Example 4.
To reduce any additional compliance burdens, the final regulations
provide an alternative method to determine when an item of gross income
is treated as ``taken into account as AFS revenue'' under the AFS
Income Inclusion Rule. Under the ``alternative AFS revenue method'',
the taxpayer does not reduce AFS revenue by amounts that the taxpayer
lacks an enforceable right to recover if the customer were to terminate
the contract on the last day of the taxable year. The alternative AFS
revenue method is a method of accounting that applies to all items of
gross income in the trade or business that are subject to the AFS
income inclusion rule. Taxpayers using the alternative AFS revenue
method may also use the AFS cost offset method provided in the final
regulations.
Under the final regulations two additional adjustments to AFS
revenue are made in determining whether an item of gross income is
treated as ``taken into account as AFS revenue.'' These adjustments
apply both under the AFS Income Inclusion Rule and under the
alternative AFS revenue method. First, if the transaction price, as
defined in Sec. 1.451-3(a)(14), was increased because a significant
financing component is deemed to exist under the standards the taxpayer
uses to prepare its AFS, then any AFS revenue attributable to such
increase is disregarded. In such situations, total AFS revenue taken
into account over the term of the contract exceeds the stated
consideration in the contract and such excess is, for AFS purposes,
offset by a corresponding interest expense. Because such excess is
generally not imputed income for Federal income tax purposes and a
deduction for the AFS interest expense is generally not imputed for
Federal income tax purposes, it is necessary to adjust AFS revenue to
prevent the improper acceleration, or overreporting, of gross income.
If situations arise in which imputed income and imputed deductions are
also required for Federal income tax purposes, an adjustment to AFS
revenue is still appropriate as the amount and timing of the imputed
income would be outside the scope of section 451 and the regulations
thereunder. Second, to the extent that AFS revenue reflects a reduction
for (1) amounts that are cost of goods sold or liabilities that are
required to be accounted for under other provisions of the Code, such
as section 461, including liabilities for allowances, rebates,
chargebacks, rewards issued in credit card and other transactions and
other reward programs, and refunds (for example, estimated returns
based on historic practice), regardless of when any such amount is
incurred (Liability Amounts); or (2) amounts anticipated to be in
dispute or anticipated to be uncollectable, the taxpayer must increase
AFS revenue by such amounts. The Treasury Department and the IRS have
determined that adjustments for such amounts are necessary to prevent
the taxpayer from effectively taking such amounts into account for
Federal income tax purposes in a taxable year prior to the taxable year
in which they are otherwise permitted to be taken into account under
other provisions of the Code. Additionally, if AFS revenue is not
adjusted for Liability Amounts in the taxable year that such amounts
are otherwise permitted to be taken into account, then a taxpayer may
obtain an improper double benefit by taking such amounts into account
to reduce taxable income under another provision of the Code while also
deferring an equal
[[Page 813]]
amount of gross income to a later year under Sec. 1.451-3. The AFS
revenue adjustments in the final regulations do not preclude a taxpayer
from accounting for trading stamps and premium coupons under Sec.
1.451-4. However, the Treasury Department and the IRS are still
evaluating whether the rules in Sec. 1.451-4 should be modified or
clarified in light of certain financial reporting changes under ASC
606.
On a separate issue relating to the scope of the AFS Income
Inclusion Rule, taxpayers questioned, in light of the realization
discussion in footnote 872, whether the AFS Income Inclusion Rule
applies to the sale of goods. Since Example 4 of the Blue Book involves
the sale of goods, it is reasonable to conclude that Congress intended
for the AFS Income Inclusion Rule, as revised, to extend to contracts
for the sale of goods. Accordingly, as with the proposed section 451(b)
regulations, the final regulations provide that the AFS Income
Inclusion Rule applies to contracts for the sale of goods.
2. Proposed Sec. 1.451-3(b): Cost Offset for AFS Income Inclusions
Proposed Sec. 1.451-3(b) does not provide for a cost offset when
an amount is included under the AFS Income Inclusion Rule. The preamble
to the proposed section 451(b) regulations discusses reasons for not
providing a cost offset, including the potential for income distortions
and Congressional intent that a cost offset not be provided. The
preamble to the proposed section 451(b) regulations requests comments
on this issue.
Multiple commenters proposed allowing an offset for the cost of
goods sold (COGS) when income is included under the AFS Income
Inclusion Rule. Commenters pointed out that the term ``item of gross
income'' generally means total sales net of COGS. See, for example,
Sec. 1.61-3(a). Commenters also described situations where income
might be distorted by inclusions in early years of a multi-year
contract with the costs being allowed in later years without income to
offset. Commenters expressed concern that, in these situations, or more
generally, the AFS Income Inclusion Rule might operate as a tax on
gross receipts.
One commenter suggested that the statute uses the AFS as a backstop
to timing recognition of revenue because the AFS provides a good
standard by which to determine when a taxpayer receives an economic
benefit. The commenter acknowledged that there has been a policy
interest in achieving greater book-tax conformity in a variety of
areas. The commenter recommended that, if the final regulations use the
AFS to measure the receipt of an economic benefit, then the final
regulations also should reflect the AFS standards that require certain
items of income be reported ``net'' of offsetting items.
Commenters also noted that, for AFS purposes, credit card issuers
generally report interchange fees net of estimated reward costs and
report credit card late fees net of estimated uncollectable amounts.
Commenters explained that reward costs and uncollectable credit card
late fees ``are so closely aligned with the realization of income that
AFS standards require those items to be presented separately in the
revenue section of the income statement but concurrently as to
timing.'' One commenter expressed concern that not reducing interchange
fees by estimated reward costs and credit card late fees by estimated
uncollectable amounts in determining the amount of income recognized
under the AFS Income Inclusion Rule would result in the inclusion of
more income for Federal income tax purposes than was reported on the
AFS.
Accordingly, commenters recommended that the final regulations
provide that the all events test and the economic performance
requirement under section 461 should be deemed to be met for items that
are ``closely aligned'' with income amounts recognized under the AFS
Income Inclusion Rule. Commenters explained that section 461 should be
deemed to be met for items such as estimated reward costs and estimated
uncollectable late fees to the extent these items are reported on the
revenue section of the AFS as a reduction to amounts subject to the AFS
Income Inclusion Rule. One commenter further explained that this
treatment would be consistent with the clear reflection of income
doctrine of section 446. Alternatively, one commenter recommended
modifying the definition of transaction price under proposed Sec.
1.451-3(c)(6) to reduce interchange fees by the amount of reward costs
that satisfy section 461 and credit card late fees by amounts that are
considered uncollectable for AFS purposes.
The Treasury Department and the IRS have considered these comments
and have determined that a cost offset based on estimates of future
costs would be inappropriate. As discussed in the preamble to the
proposed section 451(b) regulations, allowing a cost offset based on
estimated costs would be inconsistent with sections 461, 263A, and 471,
and the regulations under those sections of the Code. In addition, a
cost offset based on estimated costs would increase the possibility of
income distortions as the costs of goods would effectively be
recovered, through income deferral, prior to the taxable year in which
the cost was actually incurred.
However, the Treasury Department and the IRS agree with comments
suggesting that taxpayers should be afforded the flexibility of
applying an offset for costs incurred against AFS income inclusions
from the future sale of inventory, the ``AFS cost offset method.''
Accordingly, a taxpayer that uses the AFS cost offset method determines
the amount of gross income includible for a year prior to the year in
which ownership of inventory transfers to the customer by reducing the
amount of revenue it would otherwise be required to include under the
AFS Income Inclusion Rule for the taxable year (AFS inventory inclusion
amount) by the cost of goods related to the item of inventory for the
taxable year, the ``cost of goods in progress offset.'' The net result
is the amount that is required to be included in gross income for that
year under the AFS Income Inclusion Rule. The deferred revenue, that
is, the revenue that was reduced by the cost of goods in progress
offset for a taxable year prior to the taxable year that ownership of
the item of inventory is transferred to the customer, is generally
taken into account in the taxable year in which ownership of the item
of inventory is transferred to the customer.
The final regulations provide that the cost of goods in progress
offset for each item of inventory for the taxable year is calculated as
(1) the cost of goods incurred through the last day of the taxable
year, (2) reduced by the cumulative cost of goods in progress offset
amounts attributable to the items of inventory that were taken into
account in prior taxable years, if any. However, the cost of goods in
progress offset cannot reduce the AFS inventory inclusion amount for
the item of inventory below zero. Further, the cost of goods in
progress offset attributable to one item of inventory cannot reduce the
AFS inventory inclusion amount attributable to a separate item of
inventory. Any cost of goods that were not used to offset AFS inventory
inclusion amounts because they were subject to limitation are
considered when the taxpayer determines the cost of goods in progress
offset for that item of inventory in a subsequent taxable year.
The cost of goods in progress offset is determined by reference to
the costs and expenditures related to each item of inventory produced
or acquired for resale, which costs have been incurred
[[Page 814]]
under section 461 and have been capitalized and included in inventory
under sections 471 and 263A or any other applicable provision of the
Code at the end of the year. However, the cost of goods in progress
offset does not reduce the costs that are capitalized to the item of
inventory produced or acquired for resale by the taxpayer under the
contract. That is, while the cost of goods in progress offset reduces
the AFS inventory inclusion amount, it does not affect how and when
costs are capitalized to inventory under sections 471 and 263A or any
other applicable provision of the Code or when those capitalized costs
will be recovered. Instead, the cost of goods in progress offset serves
only to reduce or ``offset'' any AFS income inclusion amounts for the
item of inventory and defer such amounts to the taxable year in which
ownership of the item of inventory is transferred to the customer.
The costs of goods comprising the cost of goods in progress offset
must be determined by applying the inventory accounting methods used by
the taxpayer for Federal income tax purposes. A taxpayer must calculate
its cost of goods in progress offset by reference to all costs that the
taxpayer has permissibly capitalized and allocated to items of
inventory under its inventory method, but may not consider costs that
are not properly capitalized under such method.
In the taxable year in which ownership of the item of inventory is
transferred to the customer, any revenue deferred by way of a prior
year cost offset is included in gross income in the year of the
transfer along with any additional revenue that is otherwise required
to be included in gross income under the AFS Income Inclusion Rule for
such year. Although no cost offset is permitted in such year, the
taxpayer would recover costs capitalized and allocated to the item of
inventory transferred as cost of goods sold in such year in accordance
with sections 471 and 263A or any other applicable provision of the
Code. However, if in a taxable year prior to the taxable year in which
ownership of the item of inventory is transferred to the customer,
either (A) the taxpayer dies or ceases to exist in a transaction other
than a transaction to which section 381(a) applies, or (B) the
taxpayer's obligation to the customer with respect to the item of
inventory ends other than in a transaction to which 381(a) applies or
certain section 351(a) transactions between members of the same
consolidated group, then all payments received for the item of
inventory that were not previously included in gross income as a result
of the application of the cost offset rules are required to be included
in gross income in such year.
The Treasury Department and the IRS adopted this approach in the
final regulations because the AFS cost offset method provides options
for taxpayers. All taxpayers that are required to account for income
from the sale of inventory under the AFS income inclusion rule and that
report AFS revenue in a taxable year prior to the taxable year in which
ownership of the item of inventory is transferred to the customer will
generally be required to accelerate income inclusions under such rule.
However, taxpayers have the option of using the AFS cost offset method
to reduce the amount of income they are required to accelerate under
such rule. The AFS cost offset allows taxpayers to reasonably match
income inclusions and incurred cost of goods, and more clearly reflects
income.
The final regulations adopt a cost of goods sold offset based on
incurred costs because the approach is consistent with Sec. 1.61-3 and
more objective than a cost of goods sold offset based on projected
future costs. In addition, the AFS cost offset method provides a degree
of parity for sellers of goods with service providers who deduct costs
as incurred without capitalizing the costs to inventory. A cost offset
based on projected future cost of goods sold was rejected because it is
inconsistent with sections 461(h), 263A and 471, and the regulations
under those sections of the Code. Further, Congress rejected the
deferral method for advance payments in former Sec. 1.451-5(c), which
contained a cost of goods sold offset for estimated future costs. See
Conf. Rep. at 429 fn. 880.
The AFS cost offset method is a method of accounting that applies
to all items of income eligible for the AFS cost offset method in the
trade or business. The method applies to items at the trade or business
level so that taxpayers can choose to apply the method only to trades
or businesses where the burden of determining costs incurred relative
to the related reduction in AFS income inclusion amount warrants the
adoption of the method. If a taxpayer uses the AFS cost offset method
for a trade or business it must use the method for all eligible items
in that trade or business. Further, if a taxpayer uses the AFS cost
offset method, it must also use the advance payment cost offset method
in Sec. 1.451-8(e). The advance payment cost offset method is
discussed later in this preamble. Special coordination rules exist for
taxpayers that use the AFS cost offset method and the advance payment
cost offset method and that have income from the sale of an item of
inventory that is required to be accounted for under both Sec. Sec.
1.451-3 and 1.451-8 because certain payments received for such item
meet the definition of an advance payment under Sec. 1.451-8(a)(1).
See Sec. 1.451-3(c)(1) for such coordination rules.
The AFS cost offset method reduces the amount of income from the
sale of an item of inventory that is required to be accelerated under
the AFS Income Inclusion Rule by an amount of incurred cost of goods
related to the item. However, the offsets to interchange fees and
credit card late fees recommended by the commenters are based on
estimated reward costs and uncollectable late fees rather than incurred
costs of goods. Accordingly, the final regulations do not allow a cost
offset for interchange fees, credit card late fees, and similar items
of revenue that are subject to the AFS Income Inclusion Rule and
reported net of estimated future amounts for AFS purposes.
3. Proposed Sec. 1.451-3(c)(4) and (c)(6)(ii): Revenue, Transaction
Price and Increases in Consideration
Proposed Sec. 1.451-3(c)(4) provides that, for the AFS Income
Inclusion Rule, revenue means all transaction price amounts includible
in gross income under section 61 of the Code. Proposed Sec. 1.451-
3(c)(6) provides that the transaction price is the gross amount of
consideration to which a taxpayer expects to be entitled for AFS
purposes in exchange for transferring goods, services, or other
property, but not including, among other things, ``increases in
consideration'' to which a taxpayer's entitlement is contingent on the
occurrence or nonoccurrence of a future event for the period in which
the amount is contingent.
Commenters expressed confusion about the phrase ``increases in
consideration'' because the definition of transaction price otherwise
refers to ``amounts'' and does not distinguish between increases and
decreases. Commenters asserted that there is no reason to treat
``increases'' in consideration different from other consideration
because all consideration is not realized until the taxpayer has a
fixed right to payment. Commenters concluded that any portion of the
contract price subject to a contractual contingency, for example, a
future performance, is excluded from the transaction price until the
contingency is satisfied. In addition, one commenter noted that it is
unclear when there is a contingent ``increase'' in consideration,
[[Page 815]]
and taxpayers could revise the contract terms to meet this requirement.
The Treasury Department and the IRS agree with these comments. The
term ``increases in consideration'' was meant to signal income items
that are subject to a condition precedent, such as bonus payments that
require complete performance before the taxpayer is entitled to the
bonus payment. The final regulations have been revised to remove the
reference to ``increases in consideration'' entirely. The concept is
now subsumed by the general rule that, to determine when an item of
gross income is ``taken into account as AFS revenue'' under the AFS
Income Inclusion Rule, AFS revenue is reduced by amounts that the
taxpayer does not have an enforceable right to recover if the customer
were to terminate the contract at the end of the taxable year. If an
amount is contingent due to a condition precedent, such as with some
bonus payments, and the taxpayer would not have an enforceable right to
recover such amount if the customer were to terminate the contract at
the end of the taxable year, the AFS Income Inclusion Rule does not
require the taxpayer to include such amount in gross income in the
current year.
4. Proposed Sec. 1.451-3(c)(6)(ii): Rebuttable Presumption
Proposed Sec. 1.451-3(c)(6)(ii) provides a rebuttable presumption
that amounts included in revenue in an AFS are presumed to not be
contingent on the occurrence or nonoccurrence of a future event unless,
upon examination of all the facts and circumstances existing at the end
of the taxable year, it can be established to the satisfaction of the
Commissioner that the amount is contingent on the occurrence or
nonoccurrence of a future event.
Commenters requested that the final regulations remove the
rebuttable presumption regarding contingent consideration. Commenters
reasoned that the rebuttable presumption imposes a higher standard of
proof upon taxpayers than is ordinarily required to establish that
consideration is contingent. Additionally, commenters noted that basing
the presumption on the treatment of the consideration for financial
reporting purposes is not sensible because the financial accounting
rules do not make the conclusion dependent on whether the consideration
is or is not contingent on the occurrence or non-occurrence of a future
event. Rather, under the Financial Accounting Standards Board (FASB)
and International Accounting Standards Board, Accounting Standards
Codification (ASC) Topic 606 and International Financial Reporting
Standards (IFRS) 15, Revenue from Contracts with Customers
(collectively, ASC 606), the recognition of contingent consideration is
based on a determination of the likely outcome of the contingency.
Accordingly, commenters recommended that the final regulations
eliminate the presumption in favor of noncontingency.
As noted earlier, the final regulations have been revised to remove
the reference to ``contingent consideration'' entirely. The concept is
now subsumed by the general rule that, to determine when an item of
gross income is ``taken into account as AFS revenue'' under the AFS
Income Inclusion Rule, AFS revenue is reduced by amounts that the
taxpayer does not have an enforceable right to recover if the customer
terminates the contract at the end of the taxable year. Given this
change, the final regulations remove the rebuttable presumption that a
taxpayer has an enforceable right to amounts included in AFS revenue.
5. Proposed Sec. 1.451-3(c)(6)(ii): Enforceable Right to Payment
Commenters requested that the final regulations clarify or remove
the rule in proposed Sec. 1.451-3(c)(6)(ii) that treats amounts for
which the taxpayer has an ``enforceable right to payment'' for
performance completed to date as not contingent on the occurrence or
nonoccurrence of a future event. First, commenters reasoned that the
rule is ambiguous, resulting in controversies with exam. Second,
commenters asserted that, assuming the phrase ``enforceable right to
payment'' is based on the financial statement rules in ASC 606, this
standard effectively overrides the tax realization requirement
requiring a fixed, unconditional right to payment. Further, commenters
reasoned that the rule is inconsistent with the exception for increases
in consideration to which a taxpayer's entitlement is contingent on the
occurrence or nonoccurrence of a future event.
The Treasury Department and the IRS agree with these comments. As
discussed earlier, the final regulations modify the general AFS Income
Inclusion Rule by reducing the AFS revenue that is accelerated and
included in gross income. Under the AFS Income Inclusion Rule, to
determine when the item of gross income is ``taken into account as AFS
revenue,'' AFS revenue is reduced by amounts that the taxpayer does not
have an ``enforceable right'' to recover if the customer were to
terminate the contract on the last day of the taxable year. The term
``enforceable right'' is specifically defined in Sec. 1.451-3(a)(9) as
any right that a taxpayer has under the terms of a contract or under
applicable federal, state, or international law, including rights to
amounts recoverable in equity or liquidated damages.
6. Proposed Sec. 1.451-3(c)(6)(iii): Reductions for Amounts Subject to
Section 461 and Disputed Income
Proposed Sec. 1.451-3(c)(6)(iii) provides that the ``transaction
price'' does not include reductions for amounts subject to section 461,
including amounts anticipated to be in dispute, returns, and rewards
issued in credit card transactions. One commenter recommended that the
final regulations clarify that rewards issued in credit card
transactions are subject to section 461 and do not reduce original
issue discount (OID) income in any circumstance, regardless of the
structure of the credit card program. The commenter requested this
clarification because taxpayers have taken different positions on the
treatment of these rewards while the IRS has taken the position that
rewards do not reduce OID income. The commenter stated that the better
approach is to treat these rewards as liabilities under section 461.
The commenter further explained that treating these rewards as amounts
subject to section 461 in all circumstances would create uniformity
among credit card issuers, reduce controversy between taxpayers and the
IRS, and ease the compliance burden on taxpayers by eliminating the
need for a facts and circumstances analysis of each credit card
program. The Treasury Department and the IRS agree with the commenter
and have modified the final regulations in Sec. 1.451-3(b)(2)(i)(A)(1)
to clarify that rewards issued in a credit card transaction are items
subject to section 461.
Commenters also questioned whether the AFS Income Inclusion Rule
modifies the treatment of income amounts subject to an actual dispute
or a clerical error (disputed income amounts). The AFS Income Inclusion
Rule does not modify the treatment of disputed income amounts. The
principles set forth in Revenue Ruling 2003-10, 2003-1 C.B. 288,
continue to apply. For example, an accrual method taxpayer does not
accrue gross income in the taxable year of sale if, during the year of
sale, the customer disputes its liability to the taxpayer. In addition,
if an accrual method taxpayer overbills a customer due to a clerical
mistake, and the customer disputes the liability in the subsequent
taxable year, the taxpayer must accrue gross income in the taxable year
of sale for the correct amount.
[[Page 816]]
Lastly, if a taxpayer ships excess quantities of goods and the customer
does not dispute the shipment and agrees to pay for the excess
quantities of goods, the taxpayer accrues gross income in the amount of
the agreed payment in the taxable year of the sale.
In response to these comments, the final regulations clarify that,
under the AFS Income Inclusion Rule, to the extent that AFS revenue was
reduced for amounts anticipated to be in dispute or anticipated to be
uncollectable, AFS revenue is increased by such amounts. Accordingly,
although ASC 606 reduces the transaction price for anticipated disputes
to determine the amount of revenue to include on an AFS, see ASC 606-
10-32-6, AFS revenue is increased for amounts anticipated to be in
dispute or anticipated to be uncollectable, because those amounts are
included in gross income until they are actually disputed.
C. Proposed Sec. 1.451-3(c)(5): Special Method of Accounting
Proposed Sec. 1.451-3(c)(5) provides a non-exhaustive list of
examples of special methods of accounting to which the AFS Income
Inclusion Rule generally does not apply. Commenters requested that the
final regulations include the methods of accounting for notional
principal contracts under Sec. 1.446-3 and the timing rules for
stripped bonds under section 1286 as examples of special methods of
accounting. The Treasury Department and the IRS adopt these comments in
the final regulations and have added additional special methods for
clarification purposes. The list of special methods of accounting
remains non-exhaustive.
D. Proposed Sec. 1.451-3(d): Exceptions to the AFS Income Inclusion
Rule
Proposed Sec. 1.451-3(d) describes the exceptions to the AFS
Income Inclusion Rule. The proposed rule clarifies that the AFS Income
Inclusion Rule does not apply unless all of the taxpayer's entire
taxable year is covered by an AFS. In addition, the AFS Income
Inclusion Rule does not cover items of income in connection with a
mortgage servicing contract. A commenter requested that an exception be
added for any amount that has not yet been realized for Federal income
tax purposes. As discussed earlier, the Treasury Department and the IRS
decline to adopt this suggestion because providing rules on realization
is beyond the scope of these final regulations.
E. Proposed Sec. 1.451-3(g): Contracts With Multiple Performance
Obligations
1. Proposed Sec. 1.451-3(g): Allocation of Transaction Price to
Contracts With Multiple Performance Obligations Subject to Section
451(b)
Proposed Sec. 1.451-3(g) provides that if a taxpayer's contract
with a customer has multiple performance obligations subject to section
451(b), transaction price is allocated to performance obligations as
transaction price is allocated to performance obligations in the
taxpayer's AFS.
The final regulations clarify that each performance obligation
yields an item of gross income that must be accounted for separately
under the AFS Income Inclusion Rule. When a contract contains multiple
performance obligations, to determine the amount of gross income
allocated to each performance obligation, the transaction price
determined under the taxpayer's applicable accounting principles, is
allocated to each corresponding item of gross income in accordance with
how the transaction price is allocated to each performance obligation
for AFS purposes. If the accounting standards used to prepare the AFS
identify a single performance obligation that yields more than one
corresponding item of gross income, the portion of the transaction
price amount that is allocated to the single performance obligation for
AFS purposes must be further allocated among the corresponding items of
gross income using any reasonable method.
The final regulations simplify the definition of transaction price.
The final regulations define the term transaction price to mean the
total amount of consideration to which a taxpayer is, or expects to be,
entitled from all performance obligations under a contract. The
transaction price is determined under the standards the taxpayer uses
to prepare its AFS. Accordingly, adjustments to the transaction price
that were reflected in the transaction price definition in the proposed
regulations have, to the extent relevant under these final regulations,
been moved to operative rules to ensure clarity. See Sec. 1.451-
3(b)(2) and (d)(3).
In addition, the final regulations clarify how the transaction
price should be allocated to the extent the transaction price includes
a reduction for liabilities, amounts anticipated to be in dispute or
anticipated to be uncollectable, or a significant financing component
that is deemed to exist under the standards the taxpayer uses to
prepare its AFS. The final regulations clarify that the taxpayer must
determine the specific performance obligation to which such reduction
relates and increase the transaction price allocable to the
corresponding item of gross income by the amount of the reduction
(specific identification approach). If it is impracticable from the
taxpayer's records to use the specific identification approach, the
final regulations allow taxpayers to use any reasonable method to
allocate the amount to the items of gross income in the contract. The
final regulations also provide that a pro-rata allocation of this
amount across all items of gross income under the contract based on the
relative transaction price amounts allocated to the items for AFS
purposes is a reasonable method.
Similarly, the final regulations clarify how the transaction price
should be allocated if the transaction price was increased because a
significant financing component is deemed to exist under the standards
the taxpayer uses to prepare its AFS. In this situation, the taxpayer
must determine the specific performance obligation to which such amount
relates and decrease the transaction price amount allocable to the
corresponding item of gross income by such amount (the ``specific
identification approach''). If it is impracticable from the taxpayer's
records to use the specific identification approach, the taxpayer may
use any reasonable method to allocate such amount to the items of gross
income in the contract. The final regulations provide that a pro-rata
allocation of such amount across all items of gross income under the
contract based on the relative transaction price amounts allocated to
the items for AFS purposes is a reasonable method.
2. Proposed Sec. 1.451-3(g): Contracts With Income Subject to Sec.
1.451-3 and Income Subject to a Special Method of Accounting
In the proposed regulations, the Treasury Department and the IRS
requested comments on the allocation of the transaction price for
contracts that include both income subject to section 451 and income
subject to a special method of accounting provision, specifically,
section 460. A commenter to the proposed regulations suggested that the
allocation provisions under section 460 and the regulations thereunder,
and not section 451(b)(4), should control the amount of gross income
from a long-term contract that is accounted for under section 460. The
commenter noted that using this approach is appropriate in light of
section 451(b)(2), which reflects Congress's intent to not disturb the
treatment of amounts for which the
[[Page 817]]
taxpayer uses a special method of accounting.
The Treasury Department and the IRS believe that a rule is
necessary to address the application of section 451(b)(2) and (4) to
contracts with income that is accounted for in part under Sec. 1.451-3
and in part under a special method of accounting and suggested rules
for public comment in the preamble of a separate notice of proposed
rulemaking published in the Federal Register on August 5, 2020 (85 FR
47508). The suggested rules provided that if an accrual method taxpayer
with an AFS has a contract with a customer that includes one or more
items of gross income subject to a special method of accounting (as
defined in proposed Sec. 1.451-3(c)(5)) and one or more items of gross
income subject to section 451, the allocation rules under section
451(b)(4) do not apply to determine the amount of each item of gross
income that is accounted for under the special method of accounting
provision. Rather, the taxpayer first allocates the transaction price
to the item(s) of gross income subject to a special method of
accounting (as determined under the special method of accounting). The
remainder of the transaction price, the ``residual amount'', is then
allocated to the items of gross income that are subject to Sec. 1.451-
3. To the extent the contract contains more than one item of gross
income that is subject to section 451, the residual amount would be
allocated to each such item in proportion to the amounts allocated to
the corresponding performance obligations for AFS purposes. The
Treasury Department and the IRS requested comments on these suggested
allocation rules. However, no formal comments were received regarding
these suggested rules.
The final regulations largely adopt the rules suggested in the
preamble to the separate notice of proposed rulemaking published in the
Federal Register on August 5, 2020 (85 FR 47508). Accordingly, the
final regulations provide that the transaction price allocation rule in
Sec. 1.451-3(d)(1) does not apply to determine the amount of each item
of gross income that is subject to a special method of accounting.
Rather, the final regulations provide that the transaction price is
first allocated to items of gross income subject to a special method of
accounting, as determined under the special method of accounting. For
this purpose, a special method of accounting has the meaning set forth
in Sec. 1.451-3(a)(13), except as otherwise provided in guidance
published in the Internal Revenue Bulletin (see Sec. 601.601(d)).
To determine the transaction price allocated to items of gross
income subject to a special method of accounting, the taxpayer must
first adjust the AFS transaction price by the amounts described in the
final paragraph of part II.B.1 of this Summary of Comments and
Explanation of Revisions. Accordingly, if the AFS transaction price
includes a reduction for cost of goods sold, liabilities, amounts
expected to be in dispute or anticipated to be uncollectible, or a
significant financing component that exists under the standards the
taxpayer uses to prepare its AFS, the taxpayer must increase the
transaction price amount by the amount of such reduction. If the AFS
transaction price has been increased because a significant financing
component exists under the standards the taxpayer uses to prepare its
AFS, the taxpayer must decrease the transaction price amount by the
amount of such increase.
After the taxpayer makes the adjustments to the transaction price
described earlier, the taxpayer first allocates such amount to the
item(s) of gross income subject to a special method of accounting, and
then allocates the remainder (residual amount) to the item(s) of gross
income that are subject to Sec. 1.451-3. If the contract, contains
more than one item of gross income that is subject to Sec. 1.451-3,
the taxpayer allocates the residual amount to these items in proportion
to the amounts allocated to the corresponding performance obligations
for AFS purposes or as otherwise provided in guidance published in the
Internal Revenue Bulletin (see Sec. 601.601(d)).
F. Proposed Sec. 1.451-3(i): Special Ordering Rule for Certain Items
of Income for Debt Instruments
Under proposed Sec. 1.451-3(i), if a fee is not treated by a
taxpayer as discount or as an adjustment to the yield of a debt
instrument over the life of the instrument (such as points) in its AFS,
and the fee otherwise would be treated as creating or increasing OID
for Federal income tax purposes (specified fee), then the rules in the
proposed regulations under section 451(b) apply before the rules in
sections 1271 through 1275 and the corresponding regulations. Proposed
Sec. 1.451-3(i)(2) provides three examples of specified fees: Credit
card late fees, credit card cash advance fees, and interchange fees
(specified credit card fees). Interchange fees are sometimes labeled
merchant discount in certain private label credit card transactions.
Commenters requested that the final regulations provide that
promotional discount, which also is sometimes labeled merchant
discount, is not a specified fee. Promotional discount arises when a
credit card issuer charges a fee to a merchant as compensation for
accepting a below market interest rate on a credit card balance during
a promotional period. Commenters explained that promotional discount is
generally included in income over a promotional or similar period on a
taxpayer's AFS and, despite possible alternative labeling, is, in
substance, an adjustment to the yield of a debt instrument for AFS
purposes. The Treasury Department and the IRS agree that any fee that
adjusts the yield of a debt instrument for AFS purposes over the life
of the instrument or another period should not be a specified fee.
Therefore, the final regulations do not include the phrase ``over the
life of the instrument'' in the definition of a specified fee but add
the phrase ``spread over a period of time'' to clarify the definition.
Thus, a fee that adjusts the yield of a debt instrument over a
promotional or similar period for AFS purposes, such as promotional
discount, is not a specified fee under the final regulations.
One commenter agreed that section 451(b) was not intended to affect
the application of the general OID timing rules to OID other than for
certain fees that are not treated as discount for AFS purposes,
including the specified credit card fees. Accordingly, the commenter
agreed with the rules in proposed Sec. 1.451-3(i) and the inclusion of
the general OID timing rules as a special method of accounting. Except
as provided in the preceding paragraph, the definition of specified
fees in the proposed regulations is adopted in the final regulations.
G. Proposed Sec. 1.451-3(k): Cumulative Rule for Multi-Year Contracts
The proposed regulations provide that for a multi-year contract, a
taxpayer must take into account the cumulative amounts included in
income in prior taxable years on the contract in order to determine the
amount to be included for the taxable years remaining in the contract.
The proposed regulations contain two examples that illustrate this
rule.
The final regulations clarify that if the item of gross income from
a multi-year contract is from the sale of an item of inventory and the
taxpayer uses the AFS cost offset method, the taxpayer must first
determine the ``AFS inventory
[[Page 818]]
inclusion amount'' for the taxable year. The taxpayer determines the
AFS inventory inclusion amount for the taxable year by first taking the
greater of: (1) The cumulative amount of revenue from the item of
inventory that satisfies the all events test under Sec. 1.451-1(a)
through the last day of the taxable year, less the portion of any
advance payment received that is deferred to a subsequent taxable year
under Sec. 1.451-8, if applicable, or (2) the cumulative amount of
revenue from the item of inventory that is treated as taken into
account as AFS revenue through the last day of the taxable year and
identifies the larger of the two amounts or if the two amounts are
equal, the equal amount. The taxpayer then reduces such amount by the
prior year AFS inventory inclusion amount for that item of inventory,
if any, to determine the AFS inventory inclusion amount for the current
taxable year. Lastly, the taxpayer reduces the AFS inventory inclusion
amount for the taxable year by the cost of goods in progress offset for
the taxable year (which generally equals the costs of goods in progress
for the item of inventory as of the end of the year less the portion of
such costs that were taken into account as a cost of goods in progress
offset for a prior taxable year). This net amount is the amount
required to be included in gross income in the taxable year. However,
in the taxable year in which ownership of the item of inventory is
transferred to the customer, the taxpayer performs the same ``greater
of'' computation noted earlier, but rather than subtract the prior year
AFS inventory inclusion amount for the item of inventory (which is
gross of cost offsets) from the result of the ``greater of''
computation, the taxpayer subtracts all prior year gross income
inclusions for the item of inventory from the result of the ``greater
of'' computation. This net amount is the amount required to be included
in gross income in the taxable year of ownership transfer. The effect
of this computation is that any revenue reduced by a cost offset in a
prior year is included in gross in the taxable year in which ownership
of the item of inventory is transferred to the customer. Although no
cost offset is permitted in such year, the taxpayer would recover costs
capitalized and allocated to the item of inventory transferred as cost
of goods sold in such year in accordance with sections 471 and 263A or
any other applicable provision of the Code.
In the case of any other item of gross income from a multi-year
contract, the taxpayer first compares the cumulative amount of the item
of gross income that satisfies the all events test under Sec. 1.451-
1(a) through the last day of the taxable year with the cumulative
amount of revenue from the item of gross income that is treated as
taken into account as AFS revenue through the last day of the taxable
year and identifies the larger of the two amounts (or, if the two
amounts are equal, the equal amount). The taxpayer then reduces such
amount by all prior year inclusion amounts attributable to the item of
gross income, if any, to determine the amount required to be included
in gross income in the current taxable year. Special coordination rules
for applying Sec. 1.451-8 are also provided to the extent certain
payments received under a multi-year contract are advance payments. The
analysis in the examples is updated to reflect the clarifications to
the rule.
H. Proposed Sec. 1.1275-2(l): OID Rule for Income Item Subject to
Section 451(b)
Under proposed Sec. 1.1275-2(l), notwithstanding any other rule in
sections 1271 through 1275 and Sec. Sec. 1.1271-1 through 1.1275-7,
if, and to the extent, a taxpayer's item of income for a debt
instrument is subject to the timing rules in proposed Sec. 1.451-3(i)
(including credit card late fees, credit card cash advance fees, or
interchange fees), then the taxpayer does not take the item into
account to determine whether the debt instrument has any OID. As a
result, the taxpayer does not treat the item as creating or increasing
any OID on the debt instrument. Commenters agree with these rules and
note that these rules confirm that the current treatment of items other
than specified fees will not be affected by section 451(b). The
commenters also note that removing specified fees, including specified
credit card fees, from the calculation of OID will permit taxpayers to
apply only the rules of section 451(b) to these fees, without also
having to apply the OID rules, thereby reducing taxpayer compliance
burdens. Accordingly, the Treasury Department and the IRS adopt the
rules in proposed Sec. 1.1275-2(l) in the final regulations.
I. Other Comments
1. Burial Plots and Interment Rights
Commenters request clarification on the treatment of income from
contracts with customers for the sale of burial plots or interment
rights, on a pre-need basis (pre-need contracts). The terms of the pre-
need contracts typically require the customer to make an initial down
payment and pay the balance of the sales price over several years. If
the purchaser cancels or fails to perform under the contract before the
entire purchase price is paid, commenters represent that, under every
state law, the taxpayer's sole remedy is to keep all or a portion of
the installment payments previously received from the customer as
liquidated damages. Commenters highlighted that there may be an
extended period of time between the date the pre-need contract is
executed and the date the taxpayer collects the full sales price from
the customer.
Commenters represented that ASC 606 requires the entire transaction
price from a pre-need contract, net of costs, to be included in revenue
in the year in which the parties execute the contract. However, for
Federal income tax purposes, commenters requested that the final
regulations clarify that taxpayers with pre-need contracts should not
include the unpaid balance of the transaction price in income in the
taxable year the contract is executed under the AFS Income Inclusion
Rule. In commenters' view, the sale of a burial plot should not be
treated as a completed sale for tax purposes until the entire sales
price of the burial plot is paid by the customer and ownership rights
in the burial plot are transferred. Further, the taxpayer does not have
an enforceable right to payment for the entire transaction price of the
plot if the customer cancels or fails to perform under the contract.
Commenters concluded that these taxpayers should be entitled to
recover any allocable cost basis in the burial plot before including in
gross income any of the installment payments received from the
customer. Commenters viewed the sale of a burial plot as the sale of an
interest in real property and assert that the basis recovery rules of
sections 1016 and 1001 apply to prepayments for burial plots. Under
this approach, prepayments for the purchase price of a burial plot
before the sale of the plot first decrease the taxpayer's basis in the
burial plot. See Sec. 1.1016-2(a). When the prepayments exceed the
taxpayer's basis in the burial plot, the taxpayer recognizes the excess
amount as gain. See Sec. 1.1001-1(c)(1). Accordingly, commenters
requested that the final regulations clarify the application of
sections 1001 and 1016 to the sale of pre-need burial plots.
Commenters also requested clarification on the income recognition
treatment of pre-need contracts with customers for the sale of
interment rights. Commenters noted that the ASC 606 treatment for pre-
need contracts for the sale of interment rights resemble the treatment
for pre-need contracts for the sale of burial rights. Commenters viewed
the receipt of any installment payments prior to the transfer of those
rights and prior to the payment of the
[[Page 819]]
entire transaction price to be controlled by sections 1001 and 1016,
rather than by sections 451 and 471. Under this rationale, a taxpayer's
treatment of the down payment and the installment payments from pre-
need contracts in its AFS should not determine the timing of income for
tax purposes. Instead, commenters suggested that the amounts received
before the transfer of the interment rights should be viewed as a
return of capital and a reduction in the taxpayer's basis in the
interment space.
The IRS and the Treasury Department agree that the sale of burial
plots and interment rights are governed by sections 1001 and 1016 but
consider the determination of whether a sale has occurred to be a
factual issue. If a sale has occurred under the facts and
circumstances, any income resulting from the sale is realized under
section 1001 and the right to the income is fixed, therefore the AFS
Income Inclusion Rule does not result in the acceleration of AFS
revenue. If the sale has not occurred, and the right to the future
payments is extinguished if the customer cancels the contract, the AFS
Income Inclusion Rule does not require acceleration because there is no
enforceable right to the future payments if the contract is cancelled
by the customer provided that the taxpayer is not using the alternative
AFS revenue method in Sec. 1.451-3(b)(2)(ii).
2. Book Percentage-of-Completion Method (Book PCM)
One commenter expressed interest in a Book PCM option as a special
method of accounting that taxpayers with contracts accounted for using
an over-time method of accounting for revenue under ASC 606 could elect
to include the full amount of revenue reported on its AFS without
regard to any offset or exception provided in these regulations, but
with an offset for the allocable costs reported on its AFS, with some
potential tax adjustments. Under ASC 606, the over-time method, where
taxpayers recognize revenue over time (as opposed to at a point in
time) is used for the following contracts where control over promised
goods or services is transferred over time: (1) Where the customer
controls the asset as it is created or enhanced by the entity's
performance under the contract; (2) where the customer receives and
consumes the benefits of the entity's performance as it performs under
the contract; or (3) where the entity's performance creates or enhances
an asset that has no alternative use to the entity, and the entity has
the right to receive payment for work performed to date and expects to
fulfill the contract as promised. An entity using an ``over-time
method'' recognizes revenue using either: (1) An output method, which
measures the value of the goods and services transferred to date to the
customer (for example, units produced); or (2) an input method, which
recognizes revenue based on the entity's efforts or inputs (for
example, labor hours expended, costs incurred) as compared to the
expected total costs to satisfy the performance obligation.
Other commenters expressed concern about allowing a Book PCM
option. Some commenters suggested that limiting a Book PCM option to
only taxpayers that must report revenue on a particular over-time
basis, such as an input cost-incurred method, could create more
complexity, not less. Other commenters suggested that, while a Book PCM
option might achieve some book-tax conformity, they would still want
the opportunity to take advantage of tax rules that provide more
beneficial timing than available under Book PCM, such as additional
first year depreciation. The Treasury Department and the IRS will
continue studying the feasibility and efficacy of an optional Book PCM
approach. At this time, however, the Treasury Department and the IRS
decline to adopt the Book PCM option set forth by commenters because of
the concerns raised regarding the complexity and the desire by some
taxpayers to obtain more beneficial timing under tax rules when using a
Book PCM method.
3. AFS Issues
No formal comments were received regarding the definition of AFS in
proposed Sec. 1.451-3(c)(1). Accordingly, the definition of AFS
remains largely unchanged in these final regulations. See Sec. 1.451-
3(a)(5). One commenter questioned the statutory language in section
451(b) regarding financial statements prepared using international
financial reporting standards (IFRS). Specifically, section
451(b)(3)(B) provides that a financial statement made on the basis of
IFRS is an AFS for section 451(b) if the financial statement is filed
with a foreign government agency that is equivalent to the United
States Securities and Exchange Commission (SEC) and has financial
reporting standards not less stringent than the standards imposed by
the SEC. Proposed Sec. 1.451-3(c)(1)(iii)(A) and the final regulations
Sec. 1.451-3(a)(5)(ii)(A) mirror the statutory language. The commenter
questioned whether the requirement in section 451(b)(3)(B) that the
financial reporting standards of a foreign agency or government be not
less stringent than the standards required by the SEC, refers solely to
reporting standards related to revenue or if it also refers to
reporting standards for other items that are not related to revenue.
The statutory language does not distinguish the reporting standards
between revenue and other items that are not related to revenue.
Additionally, Revenue Procedure 2004-34, which was the model for the
definition of AFS in section 451(b)(3), did not have similar language.
Accordingly, based on the plain language of the statute, if the
financial reporting standard for any item is less stringent than SEC
reporting standards, even if that standard does not relate to revenue
reporting, the statement will not be an AFS under proposed Sec. 1.451-
3(c)(1)(iii)(A) or Sec. 1.451-3(a)(5)(ii)(A) of the final regulations.
However, the financial reporting standards relativity requirement does
not prevent the IFRS financial statements from qualifying as an AFS
under proposed Sec. 1.451-3(c)(1)(iii)(B) or (C) or Sec. 1.451-
3(a)(5)(ii)(B) or (C) of the final regulations.
No formal comments were received regarding the AFS issues addressed
in proposed Sec. 1.451-3(h)(1). Accordingly, the rules regarding an
AFS that covers a group of entities (consolidated AFS rules) and
mismatched reporting periods remain largely unchanged in these final
regulations. However, the Treasury Department and the IRS are aware of
questions regarding the application of certain aspects of the
consolidated AFS rules. Under proposed Sec. 1.451-3(h)(1)(i), if a
taxpayer's results are reported on the AFS for a group of entities, the
taxpayer's AFS is the group's AFS. Proposed Sec. 1.451-3(h)(3)
provides that if a group's AFS does not separately state items, the
portion of the revenue allocable to the taxpayer is determined by
relying on the source documents that were used to create the group's
AFS.
Under the proposed regulations, it was unclear whether the portion
of the AFS revenue allocable to the taxpayer includes amounts that are
subsequently eliminated in the group's AFS (consolidated AFS).
Accordingly, the final regulations clarify that, if the consolidated
AFS does not separately state items, the portion of the AFS revenue
allocable to the taxpayer is determined by relying on the taxpayer's
separate source documents used to create the consolidated AFS and
includes amounts that are subsequently eliminated in the consolidated
AFS.
[[Page 820]]
III. Comments and Revisions Regarding Sec. 1.451-8
A. Proposed Sec. 1.451-8(b)(1)(i): Definition of Advance Payment
1. Prepayments for Pre-Need Burial Plots
Under section 451(c)(4)(A), the term advance payment means any
payment that meets the following three requirements: (1) The full
inclusion of the payment in gross income in the year of receipt is a
permissible method of accounting; (2) any portion of the advance
payment is included in revenue in an AFS for a subsequent tax year; and
(3) the advance payment is for goods, services, or such other items
that the Secretary has identified. Proposed Sec. 1.451-8(b)(1)(i)
largely mirrors the definition of an advance payment in section 4.01 of
Revenue Procedure 2004-34, which expands upon the goods, services, and
other items for which a payment can qualify as an advance payment.
One commenter requested that the Secretary exercise the authority
to broaden the definition of advance payment to include prepayments for
the sale of an interest in real property, including pre-need burial
plots. If the comment is adopted, prepayments for pre-need burial plots
would be eligible for the one-year deferral of income.
Commenters agreed that taxpayers in the death care industry
uniformly treat the entire amount of the sales price for pre-need
burial plots as income on an AFS in the year the pre-need contract is
executed. To qualify as an advance payment, a portion of the prepayment
must be included in revenue by the taxpayer in an AFS for a subsequent
taxable year. Section 451(c)(4)(A)(ii). Since prepayments for pre-need
burial plots cannot meet this requirement, these prepayments cannot
qualify as advance payments. For this reason, the Treasury Department
and the IRS decline to adopt this comment in the final regulations.
No other requests were received to expand the definition of advance
payment. Accordingly, the list of items that are included in the
definition of advance payment under proposed Sec. 1.451-8(b)(1)(i) is
unchanged.
2. Amount of Payment Included in AFS Revenue in a Subsequent Year
Under section 451(c)(4)(A) and proposed Sec. 1.451-8(a)(1)(i), for
a payment to qualify as an advance payment, a portion of the payment
must be included in revenue in an AFS for a subsequent tax year. The
final regulations clarify that to determine the amount of the payment
that is taken into account as AFS revenue, the taxpayer must adjust AFS
revenue for any amounts described in Sec. 1.451-3(b)(2)(i)(A), (C),
and (D). As a result, to the extent that AFS revenue in the taxable
year of receipt reflects, for example, a reduction for liabilities that
are required to be accounted for under provisions such as section 461
or amounts anticipated to be in dispute, AFS revenue in the taxable
year of receipt must be increased by such amounts.
The final regulations make similar clarifying changes to the
deferral method for taxpayers with an AFS in Sec. 1.451-8(c). Under
Sec. 1.451-8(c), a taxpayer that uses the deferral method must include
all or a portion of the advance payment in gross income in the taxable
year of receipt to the extent ``taken into account as AFS revenue'' as
of the end of the taxable year of receipt, and include the remaining
portion of the advance payment in gross income in the following taxable
year. To determine the extent that an advance payment is treated as
``taken into account as AFS revenue'' as of the end of the taxable year
of receipt, the taxpayer must adjust AFS revenue by the amounts
described in Sec. 1.451-3(b)(2)(i)(A), (C), and (D). Accordingly, to
the extent that AFS revenue reflects a reduction for liabilities that
are accounted for under other provisions of the Code such as section
461 or amounts anticipated to be in dispute, AFS revenue is increased
by such amounts. Further, if the transaction price, as defined in Sec.
1.451-3(a)(14), was increased because a significant financing component
is deemed to exist under the standards the taxpayer uses to prepare its
AFS, then any AFS revenue attributable to such increase is disregarded.
B. Proposed Sec. 1.451-8(b)(1)(ii)(H): Specified Good Exception
Proposed Sec. 1.451-8(b)(1)(ii) lists exceptions to the definition
of an advance payment. Specifically, proposed Sec. 1.451-
8(b)(1)(ii)(H) provides that an advance payment does not include a
payment received in a taxable year earlier than the taxable year
immediately preceding the taxable year of the contractual delivery date
for a specified good. Proposed Sec. 1.451-8(b)(8) defines the
``contractual delivery date'' as the month and year of delivery listed
in the written contract to the transaction. A ``specified good'' is
defined in proposed Sec. 1.451-8(b)(9) as a good for which: (1) The
taxpayer does not have the goods of a substantially similar kind and in
a sufficient quantity at the end of the taxable year the upfront
payment is received; and (2) the taxpayer recognizes all of the revenue
from the sale of the good in its AFS in the year of delivery. If the
prepayment satisfies the specified good exception, the prepayment is
analyzed under section 451(b) and Sec. 1.451-1.
1. Contractual Delivery Date Requirement
Some commenters generally requested that the Treasury Department
and the IRS re-examine the contractual delivery date requirement. One
commenter requested that the definition of contractual delivery date be
broadened to include contracts where the delivery date can be
reasonably determined based on all the facts and circumstances as
provided in the contract. Another commenter requested that the
exception be modified to cover any contract for the sale or production
of goods where, based on all of the facts and circumstances, it is
reasonably certain that the taxpayer's performance to which the advance
payment relates will in fact take place. The same commenter also
suggested that if the definition of the contractual delivery date was
broadened, the requirement regarding the period of time between when an
advance payment is received and the delivery date for a specified good
could be modified to require that the expected delivery date occur more
than 24 months after the advance payment is received.
The Treasury Department and the IRS decline to adopt the comments
to broaden the definition of contractual delivery date in the final
regulations because the suggested approaches would decrease
administrability and increase uncertainty for taxpayers and the
potential for litigation. Therefore, the definition of contractual
delivery date in the final regulations continues to be limited to
situations where the written contract provides the month and year of
delivery for the goods.
In addition, because the Treasury Department and the IRS are not
broadening the definition of contractual delivery date, it is not
necessary to limit the specified good exception to situations where
there is more than 24 months between the date the advance payment is
received and the contractual delivery date. The recommended rule is
more restrictive than the rule in the proposed regulation which
requires the payment to be received in a taxable year earlier than the
taxable year immediately preceding the taxable year of the contractual
delivery date. Accordingly, the Treasury Department and the IRS decline
to adopt this recommendation.
[[Page 821]]
2. Requirement That AFS Revenue Must Be Recognized in the Year of
Delivery
One commenter questioned why the specified good exception in the
proposed section 451(c) regulations is restricted to situations where
all the revenue from the sale of the good is recognized in the
taxpayer's AFS in the year of delivery. The commenter requested that
the exception be expanded to include situations where the taxpayer
recognizes the revenue for Federal income tax purposes no later than
the time when the revenue related to the production of the goods is
recognized for financial accounting purposes. As a result, taxpayers
using the over-time method to report revenue under ASC 606 could be
eligible for the exception.
Payments that qualify for the specified good exception are subject
to the general accrual method of accounting rules under section 451(a)
and (b), including the all events test under section 451(b)(1)(C) and
Sec. 1.451-1(a) and the existing case law that addresses the all
events test. The specified good exception was narrowly crafted to allow
a taxpayer meeting the requirements to evaluate its treatment of
qualifying payments under the all events test under section
451(b)(1)(C) and Sec. 1.451-1(a) and the existing case law that
addresses the all events test. Taxpayers that meet the specified good
exception criteria, unlike those taxpayers that use the over-time
method to report revenue from the sale of goods under ASC 606, are
generally not required to test the payment for inclusion under the AFS
income inclusion rule in section 451(b)(1)(A), as the payment is not
taken into account as AFS revenue until the specified good is delivered
to the customer, and is only required to analyze the payment for
inclusion under the all events test in section 451(b)(1)(C).
Additionally, taxpayers that use the over-time method under ASC 606
generally incur production costs as AFS revenue is recognized and can
therefore benefit from the advance payment cost offset method under
Sec. 1.451-8(e). However, taxpayers that use the point-in-time method
to report revenue from the sale of goods under ASC 606 and that meet
the rest of the specified good exception criteria generally don't incur
production costs until closer to the delivery date and may not be able
to benefit from the advance payment cost offset method under Sec.
1.451-8(e). For these reasons, the Treasury Department and the IRS
decline to expand the specified good exception to situations where
taxpayers are using the over-time method to report revenue under ASC
606.
For this reason, the Treasury Department and the IRS do not adopt
this comment. Therefore, the definition of specified good in the final
regulations retains the requirement that the taxpayer recognizes all of
the revenue from the sale of the good in its AFS in the year of
delivery.
3. Integral Services
A commenter requested that the definition of ``specified good'' in
proposed Sec. 1.451-8(b)(8) be expanded to include ``integral
services'' furnished for the good. However, the commenter provided no
definition of integral services, a term which could be broadly
construed resulting in audit controversies. Moreover, the Conference
Report expresses Congress' intent for section 451(c) to override former
Sec. 1.451-5, which defined an advance payment to include prepayments
for services that were integral to the sale or disposition of goods.
See H.R. Rep. No. 115-466, at 429 fn. 880 (2017) (Conf. Rep.). For
these reasons, the Treasury Department and the IRS decline to accept
this comment.
4. Reasonable Estimate of Unused Net Operating Loss (NOL)
One commenter requested that, if certain proposed changes to the
specified good exception are not adopted, the Treasury Department and
the IRS should include an exclusion to the definition of ``advance
payment'' for prepayments where the taxpayer reasonably estimates,
based on the facts at the time the agreement is entered into, that it
will have a NOL that remains unused for the 5-year period after the
year the prepayments received are included in the taxpayer's taxable
income. The requested rule would be difficult to administer because it
requires a taxpayer to estimate that it will have an NOL that remains
unused for a 5-year period after the advance payments are included in
gross income. Accordingly, the Treasury Department and the IRS decline
to adopt this comment in the final regulations.
5. Tax Consequences of Meeting the Specified Good Exception
Several commenters provided examples in which payments that qualify
for the specified good exception in proposed Sec. 1.451-8(a)(1)(ii)(H)
are deferred and included in gross income when the payment is
recognized as revenue in the taxpayer's AFS in the year the good is
delivered. As mentioned in part III.B.2 of this Summary of Comments and
Explanation of Revisions and for additional clarification, payments
that qualify for the specified good exception are subject to the
general accrual method of accounting rules under section 451(a) and
(b), including the all events test under section 451(b)(1)(C) and Sec.
1.451-1 and the existing case law that addresses the all events test.
6. Method To Treat Prepayments Satisfying the Specified Good Exception
as Advance Payments
One commenter asked that the specified good exception be made
optional, particularly if meeting the specified good exception does not
result in deferral of the prepayment to match the book timing of the
payment. The commenter noted that some taxpayers may prefer the section
451(c) regime, especially if there is some uncertainty whether the
contract meets the specified good exception. Further, some taxpayers
that had the choice of a longer deferral under Sec. 1.451-5 or a one-
year deferral under Revenue Procedure 2004-34 still chose the 1-year
deferral.
The Treasury Department and the IRS agree with this comment.
Accordingly, the final regulations allow taxpayers to treat all
prepayments that satisfy the specified good exception as advance
payments subject to section 451(c), the ``specified good section 451(c)
method.'' See Sec. 1.451-8(f). The requested election provides
flexibility for taxpayers. If the taxpayer does not use the specified
good section 451(c) method, payments satisfying the specified good
exception are not eligible for the deferral method provided in section
451(c) and Sec. 1.451-8 but are subject to section 451(b) and Sec.
1.451-1(a). If the taxpayer uses the specified good section 451(c)
method, the prepayment is generally deferred for one year; however, if
a taxpayer also uses the advance payment cost offset method under Sec.
1.451-8(e) to account for such prepayments, a portion of the prepayment
may be deferred until the year in which ownership of the good is
transferred to the customer.
The specified good section 451(c) method is a method of accounting.
The method applies to all payments that satisfy the specified good
exception that are received by each trade or business that uses the
method. The use of this method results in the adoption of, or a change
in, a method of accounting under section 446. See Sec. 1.451-8(g).
C. Proposed Sec. 1.451-8(c)(2)(i)(B): Acceleration of Advance Payments
Under proposed Sec. 1.451-8(c)(2)(i)(B), a taxpayer that uses the
deferral method generally includes an advance payment in gross income
when it satisfies its
[[Page 822]]
obligation for the advance payment. Example 11 of proposed Sec. 1.451-
8(c)(8)(xi) provides an example of a travel agent that received
commission income when it purchased and delivered the ticket to the
customer but did not include the commission in revenue in its AFS until
the following year. The example concludes that the commission is not an
advance payment because it was not earned by the taxpayer in a
subsequent taxable year.
Example 11 incorrectly concludes that the payment for the
commission is not an advance payment. The payment for the commission
income is an advance payment because it meets the definition of an
advance payment under section 451(c)(4), including the requirement that
a portion of the payment is included in the taxpayer's revenue in an
AFS for a subsequent taxable year. However, the commission income is
included in income in the year of receipt because the taxpayer's
obligation with respect to the advance payment was satisfied in that
year. Accordingly, in the final regulations, this example has been
moved and revised into an example of the rules on the acceleration of
advance payments. In addition, the analysis has been changed to clarify
that (1) the commission income is an advance payment, and (2) the
taxpayer's satisfaction of its obligation for the advance payment
caused the commission to be included in income in the year of receipt.
D. Proposed Sec. 1.451-8(c)(5): Contracts With Multiple Performance
Obligations
Section 451(c)(4) provides that for purposes of the rules for
advance payments, rules similar to the rules in section 451(b)(4),
which allocate transaction price among multiple performance
obligations, apply. Proposed Sec. 1.451-8(c)(5) provides rules for
taxpayers with an AFS for allocating the transaction price when there
is more than one performance obligation in a contract. Specifically,
those taxpayers allocate the transaction price based on the method in
proposed Sec. 1.451-3(g), namely, using the allocation in the
taxpayer's AFS. No formal comments were received on this provision.
Under the proposed regulations it was not clear whether the
taxpayer was required to allocate the payment to multiple performance
obligations based on their relative transaction price or based on the
payment allocation used for AFS purposes. Accordingly, the final
regulations clarify that advance payments received under a contract
with multiple performance obligations are allocated to the
corresponding item of gross income in the same manner that the payments
are allocated to the performance obligations in the taxpayer's AFS.
This rule is consistent with the requirement in section 451(c)(4)(D)
that ``rules similar to the rules in [section 451](b)(4) shall apply,''
because it follows the manner in which the taxpayer allocates the
payment for AFS purposes.
The rule for taxpayers without an AFS remains unchanged. See Sec.
1.451-8(d)(4).
2. Proposed Sec. 1.451-8(c)(6): Contracts With Advance Payments That
Include Items Subject to a Special Method of Accounting
The proposed regulations requested comments on the allocation of a
payment when the contract includes income subject to section 451(c) and
income subject to section 460, but no comments were received.
Consistent with the objective criteria standard under Section
5.02(4) of Rev. Proc. 2004-34, the final regulations provide that if
(1) a contract with a customer includes item(s) of gross income subject
to a special method of accounting and item(s) of gross income described
in Sec. 1.451-8(a)(1)(i)(C), and (2) the taxpayer receives an
allocable payment, then the taxpayer must determine the portion of the
payment allocable to the items of gross income described in Sec.
1.451-8(a)(1)(i)(C) based on objective criteria. The taxpayer is deemed
to satisfy the objective criteria standard when it allocates the
payment to each item of gross income in proportion to the amounts
determined in Sec. 1.451-3(d)(5) or as otherwise provided in guidance
published in the Internal Revenue Bulletin (see Sec. 601.601(d)).
This rule is consistent with the requirement in section
451(c)(4)(D) that ``rules similar to the rules in [section 451](b)(4)
shall apply.'' The final regulations also provide a similar allocation
rule for taxpayers using the non-AFS deferral method.
E. Cost Offset for Advance Payments
The proposed regulations do not provide for a cost offset. The
preamble to the proposed regulations explains the rationale for
rejecting a cost offset and requests comments on this issue.
As they did with respect to the proposed section 451(b)
regulations, commenters requested that the final regulations under
section 451(c) provide a cost offset, such as a COGS offset for
expected future costs against advance payments for the sale of goods.
Commenters asserted that a COGS offset is supported by the definition
of ``receipt'' in section 451(c)(4)(C), which refers to an ``item of
gross income.'' Under section 61 and Sec. 1.61-3(a), for the sale of
goods, an item of gross income generally means total sales revenue
minus the cost of goods sold. Commenters cited Hagen Advertising
Displays, Inc. v. Commissioner, 407 F.2d 1105 (6th Cir. 1969), as
support for this position. In Hagen Advertising, the Sixth Circuit
Court of Appeals acknowledged that, to determine the proper amount of
gross income for advance payments for the sale of goods to be delivered
in the future, it would be appropriate for a taxpayer to reduce the
amount of the advance payment by the estimated cost of the goods to be
delivered. Otherwise, denying an offset for related COGS would tax the
return of capital. Id. at 1110. Accordingly, commenters asserted that
denying a COGS offset could result in an impermissible tax on gross
receipts.
Commenters also asserted that not allowing a cost offset could
result in a mismatch of revenue and costs and fails to clearly reflect
income. According to commenters, a taxpayer would be required to report
the full amount of an advance payment in income, in excess of the
expected profit associated with that portion of the total contract
price being reported. When the costs are actually incurred in
subsequent years, the taxpayer would report losses with no associated
revenue, which, in extreme cases where the losses cannot be used, could
result in a permanent loss of the tax benefit of the cost. For a
limited-life business, the acceleration of revenue recognition may
result in NOLs that are permanently lost, as expenses trail income
throughout the life cycle of the business. The commenters pointed out
that this mismatch of income and associated costs does not reflect the
reality of the overall amount of gross income realized by the taxpayer
on the contract as a whole.
Further, commenters reasoned that allowing a cost offset under
section 451(c) will not violate the economic performance requirement of
section 461(h). Since the acceleration of advance payments under
section 451(c) is a departure from accrual method accounting, the costs
related to the payments should also depart from accrual method
concepts. Commenters pointed out that the allowance of a cost offset
for expected future COGS against substantial advance payments under
former Sec. 1.451-5(c), based on Hagen Advertising, coexisted with
section 461(h) for over 33 years. In addition, the purpose of section
461(h) was not to eliminate an offset for estimated COGS for inventory
to be delivered in the near future, but to defer a deduction for costs
where the obligation was fixed but was
[[Page 823]]
going to be performed many years in the future. Here, commenters
asserted that a COGS offset would help to determine the proper amount
of gross income to be accelerated, which is not what the economic
performance requirement was intended to prevent.
Commenters also reasoned that section 451(c) was not meant to
codify all aspects of Revenue Procedure 2004-34, including the lack of
a cost offset in Revenue Procedure 2004-34. Announcement 2004-48, 2004-
1 C.B. 998, explains that a COGS offset was not permitted in Revenue
Procedure 2004-34 because it was inconsistent with the simplification
that the revenue procedure was meant to achieve, and taxpayers could
still qualify for a COGS offset under former Sec. 1.451-5(c).
Commenters also found it significant that the term ``receipt'' in
section 451(c) uses the specific term ``an item of gross income,''
while the definition of received in Revenue Procedure 2004-34 uses the
general term ``income.''
The Treasury Department and the IRS have considered these comments
and have determined that a cost offset based on estimates of future
costs would be inappropriate. As discussed in the preamble to the
proposed section 451(c) regulations, allowing a cost offset based on
estimated costs would be inconsistent with sections 461, 263A, and 471,
and the regulations under those sections of the Code and difficult for
the IRS to administer. Additionally, allowing a cost offset based on
estimated costs is inconsistent with Congress' intent to override
former Sec. 1.451-5(c). Former Sec. 1.451-5(c) permitted a cost
offset for both incurred and estimated costs against certain advance
payments that were required to be included in gross income in a taxable
year prior to the year in which ownership of the item of inventory was
transferred to the customer, and was recently withdrawn in final
regulations published in the Federal Register on July 15, 2019. See
H.R. Rep. No. 115-466, at 429 fn. 880 (2017) (Conf. Rep.); see also, 84
FR 33691 (July 15, 2019). However, the Treasury Department and the IRS
agree with comments suggesting that taxpayers should be afforded the
flexibility of applying an offset for costs incurred against advance
payments for the future sale of inventory. In this case, the final
regulations provide that a taxpayer determines the amount of the
advance payment that is included in gross income for the taxable year
by reducing the amount that would otherwise be included in gross income
for such taxable year under the taxpayer's full inclusion method or
deferral method, as applicable (advance payment inventory inclusion
amount) by the cost of goods related to the item of inventory, the
``cost of goods in progress offset.'' The method allows taxpayers to
offset advance payments included in income under either the full
inclusion method or under the deferral method. The portion of any
advance payment that is offset by a cost of goods in progress offset
for a taxable year is deferred and generally included in gross income
in the taxable year in which ownership of the item of inventory is
transferred to the customer.
Specifically, the final regulations provide that the cost of goods
in progress offset for an item of inventory for each taxable year is
calculated as the cost of goods incurred for such item through the last
day of the taxable year, reduced by the cumulative cost of goods in
progress offset amounts in prior taxable years, if any. However, the
cost of goods in progress offset cannot reduce the advance payment
inventory inclusion amount for the taxable year below zero. Further,
the cost of goods in progress offset attributable to one item of
inventory cannot reduce the advance payment inventory inclusion amount
attributable to a separate item of inventory. Any incurred costs that
were not used to offset the advance payment for the item of inventory
because they were subject to limitation are considered when the
taxpayer determines the cost of goods in progress offset in a
subsequent taxable year. In addition, the cost of goods in progress
offset does not apply to the advance payment inventory inclusion amount
that is included in gross income as a result of the acceleration rules
in Sec. 1.451-8(c)(4), and any advance payments previously deferred by
way of a cost of goods in progress offset in a prior year are
accelerated under such rule.
The cost of goods in progress offset is determined by reference to
the costs and expenditures related to items of inventory produced or
acquired for resale, which costs have been incurred under section 461
and have been capitalized and included in inventory under sections 471
and 263A or any other applicable provision of the Code as of the end of
the year. The taxpayer must be able to demonstrate that the costs are
properly capitalizable under the Code to the items of inventory
produced or acquired for resale under the contract to which the
taxpayer is applying the cost of goods in progress offset. For a sale
of a gift card or customer reward program points, this requirement
cannot be met, and no cost of goods in progress offset is permitted.
However, the cost of goods in progress offset does not reduce the costs
that are capitalized to the items of inventory produced or acquired for
resale by the taxpayer under the contract. That is, while the cost of
goods in progress offset reduces the amount of the advance payment
included in income, it does not affect how and when costs are
capitalized to inventory under sections 471 and 263A or any other
applicable provision of the Code or when those capitalized costs will
be recovered.
The costs of goods comprising the cost of goods in progress offset
must be determined by applying the taxpayer's inventory accounting
methods. A taxpayer must calculate its cost of goods in progress offset
by reference to all costs that the taxpayer has permissibly capitalized
and allocated to items of inventory under its method of accounting for
inventories for federal income tax purposes, but may not consider costs
that are not properly capitalized under such method.
The Treasury Department and the IRS provided this cost offset
method in the final regulations because it provides a reasonable
matching of income from advance payments and incurred cost of goods,
and more clearly reflects income. The advance payment cost offset
method is a method of accounting that applies to all advance payments
received by a trade or business for items of inventory that satisfy the
criteria in Sec. 1.451-8(e). If a taxpayer chooses to use the advance
payment cost offset method for a trade or business, it must also use
the AFS cost offset method in Sec. 1.451-3(c) for that trade or
business. See prior discussion regarding coordination between the AFS
cost offset method and the advance payment cost offset method.
Additional guidance on the cost offset method for advance payments may
be provided in guidance published in the Internal Revenue Bulletin (see
Sec. 601.601(d)).
F. Continued Application of Revenue Procedure 2004-32 and Revenue
Procedure 79-38
Commenters requested clarification of whether Revenue Procedure
2004-32, 2004-1 C.B. 988, and Revenue Procedure 79-38, 1997-2 C.B. 501,
remain in effect after the enactment of section 451(c). Revenue
Procedure 2004-32 allows an accrual method taxpayer to account for
income from credit card annual fees ratably over the period covered by
the fees, as described in section 4 of Revenue Procedure 2004-32.
Revenue Procedure 79-38 generally allows accrual method manufacturers,
wholesalers, and retailers of motor vehicles or other durable goods to
include a portion of an
[[Page 824]]
advance payment related to the sale of a multi-year service warranty
contract in gross income over the life of the service warranty
obligation. Revenue Procedure 2004-32 and Revenue Procedure 79-38
remain effective after the enactment of section 451(c) and may be
relied upon after these regulations are finalized.
Effect on Other Documents
The preamble to proposed Sec. 1.451-3 requested comments on the
proposed obsolescence of Revenue Procedure 2004-33, 2004-1 C.B. 989
(relating to credit card late fees), Revenue Procedure 2005-47, 2005-2
C.B. 269 (relating to credit card cash advance fees), Revenue Procedure
2013-26, 2013-22 I.R.B. 1160 (relating to a safe harbor method of
accounting for OID on a pool of credit card receivables), and Chief
Counsel Notice CC-2010-018 (relating to interchange). Instead of
obsoleting Revenue Procedure 2013-26, commenters recommended limiting
the scope of Revenue Procedure 2013-26 to OID that is not subject to
the timing rules in proposed Sec. 1.451-3(i) and thus, not excluded
from the OID rules under proposed Sec. 1.1275-2(l). Commenters
explained that retaining Revenue Procedure 2013-26 would allow
taxpayers to continue to use the proportional method described in the
revenue procedure as a safe harbor method of accounting for certain
amounts that are not OID under section 1272, such as bond premium and
market discount, as well as certain kinds of OID such as promotional
discount. See discussion of promotional discount in part II.F. of the
Summary of Comments and Explanation of Revisions. The Treasury
Department and the IRS agree with the recommendations not to obsolete
Revenue Procedure 2013-26. In addition, the Treasury Department and the
IRS intend to modify Revenue Procedure 2013-26 to make clear that the
safe harbor method does not apply to any specified fees, including the
specified credit card fees. However, based on section 451(b) and the
final regulations, Revenue Procedure 2004-33, Revenue Procedure 2005-
47, and Chief Counsel Notice CC-2010-018 no longer provide current
guidance on the treatment of the specified credit card fees.
Accordingly, these items are obsolete as of January 1, 2021.
In addition, Revenue Procedure 2004-34, Revenue Procedure 2011-18,
Revenue Procedure 2013-29 and Notice 2018-35 are obsolete for taxable
years beginning on or after January 1, 2021. Taxpayers that relied on
the now obsoleted guidance should determine whether a change in method
of accounting occurs once they cease to use the obsoleted guidance.
Applicability Dates
In general, the rules in Sec. Sec. 1.451-3 and 1.451-8 apply for
taxable years beginning on or after January 1, 2021. However, the rules
in Sec. 1.451-3(j) for specified fees that are not specified credit
card fees apply for taxable years beginning on or after January 6,
2022. Also, for a specified credit card fee as defined in Sec. 1.451-
3(j)(2), Sec. 1.1275-2(l)(1) applies for taxable years beginning on or
after January 1, 2021, and, for a specified fee that is not a specified
credit card fee, Sec. 1.1275-2(l)(1) applies for taxable years
beginning on or after January 6, 2022.
However, pursuant to section 7805(b)(7), taxpayers and their
related parties, within the meaning of sections 267(b) and 707(b), may
apply the rules in these final regulations, in their entirety and in a
consistent manner, to a taxable year beginning after December 31, 2017,
and before January 1, 2021, provided that, once applied to such a
taxable year, such rules are applied in their entirety and in a
consistent manner to all subsequent taxable years. Notwithstanding the
preceding sentence, pursuant to section 7805(b)(7), taxpayers and their
related parties, within the meaning of sections 267(b) and 707(b), may
apply the rules in these final regulations that apply to specified
credit card fees in their entirety and in a consistent manner, to a
taxable year beginning after December 31, 2018, and before January 1,
2021, provided that, once applied to such a taxable year, such rules
are applied in their entirety and in a consistent manner to all
subsequent taxable years. Taxpayers that choose to apply the rules in
the final regulations to a taxable year beginning before January 1,
2021 must follow the rules for changes in method of accounting under
section 446 and the applicable procedural guidance.
Alternatively, a taxpayer may rely on the proposed regulations for
taxable years beginning after December 31, 2017 (or December 31, 2018,
in the case of specified credit card fees) and before January 1, 2021.
In the case of a specified fee that is not a specified credit card
fee, a taxpayer may neither choose to apply the final regulations to,
nor rely on the proposed regulations for, a taxable year beginning
after December 31, 2018, and before January 6, 2022.
Statement of Availability of IRS Documents
The IRS Notices, Revenue Rulings, and Revenue Procedures cited in
this document are published in the Internal Revenue Bulletin (or
Cumulative Bulletin) and are available from the Superintendent of
Documents, U.S. Government Publishing Office, Washington, DC 20402, or
by visiting the IRS website at http://www.irs.gov.
Special Analyses
I. Regulatory Planning and Review--Economic Analysis
Executive Orders 12866, 13563, and 13771 direct agencies to assess
costs and benefits of available regulatory alternatives and, if
regulation is necessary, to select regulatory approaches that maximize
net benefits (including potential economic, environmental, public
health and safety effects, distributive impacts, and equity). Executive
Order 13563 emphasizes the importance of quantifying both costs and
benefits, of reducing costs, of harmonizing rules, and of promoting
flexibility. For purposes of E.O. 13771 this rule is regulatory.
These regulations have been designated as subject to review under
Executive Order 12866 pursuant to the Memorandum of Agreement (April
11, 2018) between the Treasury Department and the Office of Management
and Budget (OMB) regarding review of tax regulations. The Office of
Information and Regulatory Affairs has designated these regulations as
economically significant under section 1(c) of the MOA. Accordingly,
the OMB has reviewed these regulations.
A. Need for the Final Regulations
The Tax Cuts and Jobs Act (TCJA) substantially modified the
statutory rules of section 451, which generally governs when income is
recognized for Federal tax purposes. As a result of those changes, the
Treasury Department and the IRS recognized that questions were likely
to arise regarding the definitions and rules that taxpayers are
required to apply in calculating a business's gross income. To provide
greater specificity, the Treasury Department and the IRS previously
issued separate proposed regulations related to section 451(b) and
451(c) on September 9, 2019.
The proposed regulations regarding section 451(b): (1) Clarify how
section 451(b) applies to multi-year contracts; (2) provide rules for
taxpayers whose financial results are included on an Applicable
Financial Statement (AFS) covering a group of entities; (3) describe
and clarify the definition of transaction price and revenue; (4)
specify the allocation of a transaction price in the
[[Page 825]]
case of a contract which contains multiple performance obligations; and
(5) specify rules for certain debt instruments.
The proposed regulations for section 451(c) describe the deferral
rules for advance payments for taxpayers with and without an AFS; (2)
provide acceleration rules for taxpayers that cease to exist; (3)
clarify the treatment of financial statement adjustments for taxpayers
with deferred advance payments; (4) provide rules relating to the
treatment of short taxable years for taxpayers deferring advance
payments; and (5) define and clarify the treatment of performance
obligations. They also list items excluded from the definition of an
advance payment. In response to taxpayer comments received during the
development of the proposed regulations, that list includes goods for
which (1) the taxpayer does not have goods of a substantially similar
kind and in a sufficient quantity at the end of the taxable year the
upfront payment is received; and (2) the taxpayer recognizes all of the
revenue from the sale of the good in its AFS in the year of delivery.
Comments were received on the proposed regulations for 451(b) and
451(c) requesting further clarification of or changes to those
regulations. Based on these comments, the Treasury Department and the
IRS determined that final regulations are needed to bring clarity to
instances where the statute may be subject to multiple interpretations
in the absence of further guidance and to respond to comments received
on the proposed regulations. Among other benefits, the final
regulations provide greater certainty and consistency in the
application of section 451 by taxpayers and the IRS.
B. Background and Overview of Final Regulations
Under section 451(a) of the Code, income is ``recognized'' (that
is, included in gross income for tax purposes) in the year in which it
is received by the taxpayer unless it is properly accounted for in a
different period under the taxpayer's method of accounting. Because of
this latter condition, the tax treatment of certain items of income
depends on the method of accounting a taxpayer is using. For taxpayers
using the accrual method of accounting, income is generally recognized
in the year in which all events have occurred that fix the right to
receive that income and the amount of income can be determined with
reasonable accuracy (all events test).
The timing of income recognition on a firm's financial statement
may deviate from these principles. Both the U.S. generally accepted
accounting principles (GAAP) and the international financial reporting
standards (IFRS) provide income recognition rules that differ from tax
reporting rules under certain circumstances. For example, financial
accounting rules may require revenue to be recognized when the costs of
providing goods or services pursuant to a contract are incurred, while
the all-events test may not be satisfied until the contract obligation
is fulfilled. New accounting standards released by the Financial
Accounting Standards Board (FASB) and the International Accounting
Standards Board (IASB) in 2014 further accelerated the timing of income
recognition for financial reporting purposes, widening the gap between
financial and tax reporting.
The timing of income recognition for tax purposes may also deviate
from the all-events test in certain circumstances. For instance,
receipt of payment by the business satisfies the all events test.
However, recognition of certain payments for goods or services not yet
provided may be deferred to the year following receipt of payment, to
the extent that recognition is also deferred on the taxpayer's AFS.
Such payments are referred to as ``advance payments.''
Prior to the enactment of TCJA on December 22, 2017, taxpayers were
generally permitted to defer the tax on these advance payments; in
other words, advance payments could be recognized in a later taxable
year. Under prior law, the period over which an advance payment was
deferred varied depending on the alternative regulatory treatment
chosen (Revenue Procedure 2004-34 or Sec. 1.451-5) and, within Sec.
1.451-5, the type of good for which an advance payment was accepted
(inventoriable goods versus non-inventoriable goods).
Under Revenue Procedure 2004-34, a taxpayer who receives an advance
payment includes the advance payment in taxable income in the year of
receipt to the extent that the payment is earned (if the taxpayer does
not have an AFS) or, if the taxpayer has an AFS, to the extent that the
payment is included in revenues in the AFS. The taxpayer includes the
remaining amount of the advance payment in taxable income in the next
taxable year, unless the next taxable year is a short year of 92 days
or less. In the event of such a short year, the taxpayer includes in
taxable income the part of the advance payment included in revenue in
the AFS for the short tax year or, in the case of a taxpayer that does
not have an AFS, the part of the advance payment which is earned in the
short tax year. The remaining balance of the advance payment is
included in income for the taxable year following the short tax year.
Revenue Procedure 2004-34 applies to numerous types of advance payments
beyond advance payments for the provision of services and sales of
goods. For example, it applies to advance payments for the use of
intellectual property and software, the occupancy or use of property if
the occupancy or use is ancillary to the provision of services,
guaranty or warranty contracts, subscriptions, memberships in
organizations, and eligible gift card sales.
Under Sec. 1.451-5, advance payments were defined more narrowly
than under Revenue Procedure 2004-34 to include payments received by an
accrual-method taxpayer for the future sale of goods held by the
taxpayer in the ordinary course of trade or business and as payments
for the building, installing, constructing, or manufacturing of goods
by the taxpayer in a future taxable year. Such advance payments were
generally included in taxable income either in the year of receipt or
in the year in which the payment was properly accruable under the
taxpayer's method of accounting.
An exception to this general rule occurred in the case of certain
advance payments for certain goods properly held in inventory by the
taxpayer. In the case of such goods, the receipt of a substantial
advance payment required that all previously unrecognized advance
payments be included in taxable income by the end of the second taxable
year following the taxable year in which the substantial advance
payment was received. The taxpayer was considered to have received a
substantial advance payment if the sum of the advance payment received
in the current taxable year and prior taxable years for the same
contract was greater than or equal to total inventoriable costs and
expenditures.
The TCJA substantially amended section 451 providing, among other
things, new rules addressing deviations from the all-events test. The
amended section 451(b) more closely aligns when income is recognized
for Federal tax purposes with when it is recognized on businesses'
financial accounting statements. In particular, section 13221 of the
TCJA amends section 451(b), such that an item of gross income must be
included in gross income no later than the period when the item is
included in revenue on an AFS. Thus, this new rule requires taxpayers
to recognize income upon the earlier of when the all-events test is met
or when the taxpayer includes the amount in revenue
[[Page 826]]
(broadly defined) in its AFS (AFS income inclusion rule). For these
taxpayers, income recognition is accelerated for tax purposes when
income has been recognized for financial accounting purposes before the
all events test has been satisfied.
The amendments made to section 451(b) only apply to taxpayers that
use accrual accounting and have an AFS. Neither the statutory changes
to 451(b) nor the final regulations regarding 451(b) change the time at
which income is recognized for accrual method taxpayers without an AFS.
Section 451(c), added by the TCJA, allows accrual-method taxpayers
to elect to recognize as income only a portion of an advance payment in
the taxable year in which it is received, and then recognize the
remainder in the following taxable year. Section 451(c) essentially
codifies the deferral method of accounting for advance payments that
was permitted in Revenue Procedure 2004-34. (Joint Committee on
Taxation, General Explanation of Public Law 115-97, (Washington, U.S.
Government Publishing Office, December 2018), at 167.) The new section
451(c), a subject of the final regulations, addresses how advance
payments are defined and when they need to be recognized in a
business's gross income.
C. Economic Analysis
1. Baseline
In this analysis, the Treasury Department and the IRS assess the
benefits and costs of the final regulations relative to a no-action
baseline reflecting anticipated Federal income tax-related behavior in
the absence of these final regulations.
2. Summary of Economic Effects
The final regulations provide certainty and consistency in the
application of sections 451(b) and 451(c) by providing definitions and
clarifications regarding the statute's terms and rules. In the absence
of the guidance provided in these final regulations, the chance that
different taxpayers might interpret the statute differently is
exacerbated. For example, two similarly situated taxpayers might
interpret the statutory provisions pertaining to the definition of
advanced payments differently, with one taxpayer pursuing a project
that another comparable taxpayer might decline because of a different
interpretation of how the income may be treated under section 451(c).
If this second taxpayer's activity is more profitable, an economic loss
arises. Similar situations may arise under each of the provisions
addressed by these regulations. Certainty and clarity over tax
treatment generally also reduce compliance costs for taxpayers.
An economic loss might also arise if all taxpayers have similar
interpretations under the baseline of the tax treatment of particular
items of income but those interpretations differ slightly from the
interpretation Congress intended for these income streams. For example,
the final regulations may specify a tax treatment that few or no
taxpayers would adopt in the absence of specific guidance but that
nonetheless advances Congressional intent. In these cases, guidance
provides value by bringing economic decisions closer in line with the
intent and purpose of the statute.
While no guidance can curtail all differential or inaccurate
interpretations of the statute, the final regulations significantly
mitigate the chance for differential or inaccurate interpretations and
thereby increase economic efficiency.
Because the final regulations clarify the tax treatment of items of
gross income for certain taxpayers, there is the possibility that
business decisions may change as a result of these regulations. The
final regulations generally have the effect of delaying the timing of
tax liability, thus reducing effective tax rates for affected
taxpayers. This reduction in effective tax rates, viewed in isolation,
will generally lead to an increase in economic activity by these
taxpayers.
This delay in the timing of tax liability, viewed in isolation,
will also decrease Federal tax revenue. A decrease in Federal tax
revenue either increases the deficit or necessitates increases in other
taxes or a reduction in spending. This revenue effect will be mitigated
to some degree by improved economic performance (and accompanying tax
revenues) under these regulations due to (i) the enhanced alignment in
the timing of taxes on income and costs; (ii) the enhanced certainty
and clarity provided by the final regulations as described previously;
and (iii) enhanced economic activity due to lower effective tax rates
for affected taxpayers.
The Treasury Department and the IRS have not estimated these
effects relative to the no-action baseline or alternative regulatory
approaches because they do not have readily available data or models
that measure: (i) The volume of cost offsets allowed under the final
regulations; \1\ (ii) the effect on economic activity by affected
taxpayers from the enhanced alignment of income and costs under the
final regulations relative to the no-action baseline or alternative
regulatory approaches; (iii) the tax positions that taxpayers would
take on other provisions of the final regulations, relative to the no-
action baseline or alternative regulatory approaches; or (iv) the
economic activities that taxpayers would engage in under those tax
positions.
---------------------------------------------------------------------------
\1\ Cost offsets are not reported on current tax returns and
will not be separately reported on future tax returns.
---------------------------------------------------------------------------
The Treasury Department and the IRS have also not made projections
of any change in compliance costs arising from the final regulations,
relative to the no-action baseline. Treasury generally projects that
compliance costs will be lower under the final regulations relative to
the no-action baseline because enhanced clarity and certainty reduce
compliance costs. The Treasury Department and the IRS recognize that
some taxpayers may take advantage of favorable provisions in the final
regulations and that this decision could increase their compliance
costs. Taxpayers would not take advantage of these provisions, however,
unless the overall treatment was beneficial to the taxpayer.
The proposed regulations noted that the economic analysis of the
final regulations under section 451(c) would address the economic
effects of regulatory guidance, if any, under sections 460 and 461(h)
or other sections of the Code that interact with section 451(c), that
was issued between the proposed and final regulations. Since the
release of the proposed regulations on September 5, 2019, no such
regulatory guidance has been issued.
The proposed regulations for 451(b) and 451(c) solicited comments
on the economic effects of the proposed regulations. No such comments
were received.
3. Number of Affected Taxpayers
The Treasury Department and the IRS estimate that between 174,000
and 299,000 entities are likely to be affected by the final
regulations.
Section 451(b) and (c) and the regulations under Sec. 1.451-3
affect only those business entities that (i) use an accrual method of
accounting, and (ii) have an AFS. One provision in Sec. 1.451-8
applies to accrual method taxpayers without an AFS. Regarding the
accrual method of accounting, section 13102 of TCJA modified section
448 to expand the number of taxpayers eligible to use the cash receipts
and disbursements method of accounting (cash method of accounting). In
general, C corporations and partnerships with a C corporation
[[Page 827]]
partner are now permitted to use the cash method of accounting if
average annual gross receipts are $25 million or less for taxable years
beginning in 2018 (up from $5 million or less in 2017). This amount was
adjusted for inflation for taxable years beginning after December 31,
2018. The amount was $26 million in taxable year 2019.
The statute and the regulations generally affect only those
entities that also have an AFS although one provision in the
regulations under Sec. 1.451-8 applies to non-AFS taxpayers. The
Treasury Department and the IRS do not have readily available data to
measure the prevalence of these affected entities. However, Schedule M-
3, which is used to reconcile an entity's net income or loss for tax
purposes with its book income or loss, reports whether an entity has a
certified audited income statement. Schedule M-3 is required to be
filed only by entities with at least $10 million of assets. This
population is more likely to possess an AFS and, conversely, entities
that do not file Schedule M-3 are less likely to possess an AFS or
otherwise be affected by the regulations as owners and/or creditors of
such smaller entities are less likely to require the entity to certify
its financial results via a financial statement audit. Data are
currently available only for electronic filers.
The Treasury Department and the IRS estimated the number of
affected taxpayers separately for entities with gross receipts of $26
million or less and those with gross receipts above $26 million. For
taxable year 2017, 89 percent of accrual-method entities filing Forms
1120, 1120-S, and 1065 with gross receipts of $26 million or less were
filers of electronic tax forms. About 11 percent, or 288,000 returns,
included a Schedule M-3. About 40 percent of the returns with Schedule
M-3, or 113,000, indicated they had a certified audited income
statement.\2\ Based on the assumption that filers of paper tax forms
have the same incidence as electronic filers and that entities that do
not file a Schedule M-3 generally do not have an AFS, then the Treasury
Department and the IRS estimate that roughly 127,000 (113,000/0.89)
entities with gross receipts of $26 million or less are accrual-method
entities that have an AFS. If 5 percent of entities that do not file a
Schedule M-3 also have an AFS, then approximately 251,000 of these
entities are potentially impacted by the final regulations.
---------------------------------------------------------------------------
\2\ Data are based on estimates from the IRS's Research, Applied
Analytics and Statistics Division using data from the Compliance
Data Warehouse.
---------------------------------------------------------------------------
For entities with gross receipts above $26 million and that are
accrual method entities, the comparable calculations are that 95
percent of returns are e-filed and that 73 percent of those included a
Schedule M-3. Based on the assumption that filers of paper tax forms
have the same incidence as electronic filers and that entities that do
not include a Schedule M-3 generally do not have an AFS, the Treasury
Department and the IRS estimate that 47,000 (45,000/0.95) entities with
gross receipts above $26 million are accrual-method entities that have
an AFS. If 5 percent of entities that do not file a Schedule M-3 also
have an AFS, then approximately 48,000 of these entities are
potentially affected by these regulations.
Together, these calculations imply that between 174,000 and 299,000
entities are potentially affected by the final regulations.
Corporation and Partnership Returns Using an Accrual Method of Accounting ***
[Taxable year 2017; thousands of returns]
----------------------------------------------------------------------------------------------------------------
Entities with gross receipts not Entities with gross receipts greater
greater than $26 million than $26 million
-----------------------------------------------------------------------------------
E-filed Paper-filed Total E-filed Paper-filed Total
----------------------------------------------------------------------------------------------------------------
Returns..................... 2,503 307 2,810 73 4 77
Returns with a Schedule M-3. 288 * 35 * 323 62 * 3 * 65
Returns with a Schedule M-3 113 * 14 * 127 45 * 2 * 47
and an audited income
statement..................
Returns without a Schedule M- 2,215 * 272 * 2,487 11 * 1 * 12
3..........................
Returns without a Schedule M- ** 111 ** 13 ** 124 ** 1 ** 0 ** 1
3, but with an audited
income statement
(estimated)................
Returns with an audited ** 224 ** 27 ** 251 ** 46 ** 2 ** 48
income statement...........
----------------------------------------------------------------------------------------------------------------
* Estimates are obtained by assuming paper-filed returns are similar to e-filed returns as regards the incidence
of a filing entity having a Schedule M-3 and an audited income statement.
** Estimates are obtained by assuming that 5 percent of returns without a Schedule M-3 have an audited income
statement.
*** This table does not include sole proprietorships because the number of sole proprietorships with gross
receipts above $26 million that used accrual accounting was statistically indistinguishable from zero in 2017.
The number of sole proprietorships with gross receipts of $26 million or below that are affected by these
regulations is projected to be minimal.
Source: Data compiled by the IRS Research, Applied Analytics and Statistics Division using data from the
Compliance Data Warehouse. The total number of accrual method returns of corporations and partnerships may
differ slightly from other estimates due to different data sources.
4. Economic Effects of Provisions Under Section 451(b)
a. Provisions Substantially Revised From the Proposed Section 451(b)
Regulations
i. Cost Offset Under Section 451(b)
Section 451(b) as amended by TCJA addresses the timing of revenue
recognition for tax purposes but makes no mention of the timing of cost
recognition. The Treasury Department and the IRS considered three
options for addressing the treatment of costs under section 451(b): (i)
Do not allow a cost offset; (ii) allow a cost offset for incurred
costs; and (iii) expand the allowance for incurred costs by further
allowing a cost offset for projected costs. The proposed regulations
did not provide a cost offset for the AFS income inclusion rule.
In the proposed section 451(b) regulations (in this part C.4,
proposed regulations), the Treasury Department and the IRS argued that
allowing a cost offset would be inconsistent with the economic
performance rules under section 461 and inventory accounting rules
under section 471. The proposed regulations further argued that
Congress did not make clear any intention to alter those sections of
the Code or their
[[Page 828]]
associated regulations. The proposed regulations stated, however, that
the subject was still under consideration and requested comments
addressing appropriate cost offset rules.
In response to the comments received, the Treasury Department and
the IRS have decided to include in the final regulations an offset for
the cost of goods in progress (cost offset). This cost offset allows
taxpayers to reduce the amount of revenue from the sale of inventory
that is otherwise required to be included in gross income under the AFS
income inclusion rule in a taxable year prior to the year in which
ownership of the inventory is transferred to the customer and defer
such revenue to the taxable year in which the ownership of the
inventory is transferred to the customer. The amount of such reduction,
or cost offset, is determined by reference to the inventoriable costs
incurred to date. The offset applies only to incurred costs, not
estimated or projected costs. Further, the cost offset cannot reduce
the amount of revenue that is included in gross income under the AFS
inclusion rule below zero. Any incurred costs subject to this
limitation may be carried forward to determine the cost offset in
subsequent taxable years.
The cost offset in the final regulations generally reduces the
amount of revenue that is required to be included in gross income in a
taxable year prior to the year in which ownership of inventory is
transferred to the customer relative to the proposed regulations. An
improved match of income and cost timing is generally held to provide a
more accurate measure of economic activity and thus would lead to a
more efficient tax system than under the proposed regulations, within
the context of the statute and the overall Code.
This enhanced alignment in the tax treatment of revenue and costs
can be expected to reduce financing costs for at least some projects
and taxpayers. This reduction in financing costs relative to the
proposed regulations may arise because in some cases under the proposed
regulations, the inability of taxpayers to match the timing of revenue
and cost associated with a project leads to a large, front-loaded tax
liability, which may require a costly rebalancing of other assets,
particularly for liquidity-constrained taxpayers. Taxpayers who
experience a reduction in financing costs as a result of these final
regulations, relative to the proposed regulations, may, as a result,
increase other expenditures, including investment. The provision of the
cost offset in the final regulations may further encourage longer-run
projects relative to the proposed regulations.
The Treasury Department and the IRS considered expanding the cost
offset to allow for projected costs, with several possible formats for
how projected costs would be accounted for. Allowing an offset for
projected costs would entail a higher administrative burden than the
offset (only) for incurred costs and would not definitively improve the
alignment of when income and costs are recognized for tax purposes
relative to the offset for incurred costs. The Treasury Department and
the IRS project that under an offset for projected costs, more disputes
would likely arise over the projected costs because taxpayers would
have an incentive to overstate projected costs in order to delay income
recognition.
The Treasury Department and the IRS have not estimated the
difference in compliance costs, administrative burden, or income-cost
alignment (and any subsequent effects on economic activity) between the
final regulations and alternative regulatory approaches using projected
costs. The Treasury Department and the IRS have not undertaken this
estimation because they do not have sufficiently detailed data or
models that capture possible differences in cost offset formats that
use incurred costs versus projected costs.
ii. Scope of the AFS Income Inclusion Rule
The final regulations also address concerns raised by commenters
regarding recent changes to the financial accounting standards. The
commenters suggested that the AFS inclusion rule is overly broad in
light of these new standards, which generally accelerate AFS revenue
recognition relative to the prior standards, and could cause taxpayers
to incur a tax liability before they receive, or have a fixed right to
receive, the money to pay the liability. Accordingly, the final
regulations provide that under the AFS inclusion rule, amounts taken
into account as AFS revenue include only those amounts that the
taxpayer has an enforceable right to recover if the customer were to
terminate the contract at the end of the taxable year.
The final regulations further provide, however, that a taxpayer may
treat any amount reported as AFS revenue as being taken into account as
AFS revenue regardless of whether the taxpayer has an enforceable right
to recover such amounts. The Treasury Department and the IRS project
that this option will lead to reduced compliance burden, reduced
administrative burden, and to fewer taxpayer disputes relative to an
alternative regulatory approach under which amounts taken into account
as AFS revenue include only those amounts that the taxpayer has an
enforceable right to recover if the customer were to terminate the
contract at the end of the taxable year. Under this ``enforceable
right'' approach, taxpayers would be required to analyze each contract
to determine amounts for which the taxpayer has an enforceable right to
recover if the customer were to terminate the contract at the end of
the year; this analysis would be potentially costly.
The Treasury Department and the IRS also considered an alternative
regulatory approach under which taxpayers would be permitted to defer
``increases'' in the transactions price that are taken into account as
AFS revenue in a given year but to which a taxpayer's entitlement is
contingent on a future event (contingent transaction price approach).
This alternative regulatory approach was reflected in the proposed
regulations. However, commenters expressed confusion as to what
constitutes an ``increase'' in the transaction price and the types of
contingencies that were intended to be included within the scope of the
rule. Because of the uncertainties created by the contingent
transaction price approach, and the potential for multiple
interpretations, the Treasury Department and the IRS decided against
this approach. The enforceable right standard adopted by the final
regulations may accelerate income inclusion relative to the contingent
transaction price approach, although the Treasury Department and the
IRS recognize that the opposite result may hold for some taxpayers.
The Treasury Department and the IRS have not estimated the
differences in income inclusion between the final regulations and this
alternative regulatory approach because they do not have readily
available data on the income inclusion timing differences under an
enforceable right standard versus the contingent transactions price
approach. Because of this lack of data, the Treasury Department and the
IRS have further not estimated the difference in compliance costs
between the final regulations and the alternative regulatory approach.
b. Provisions Not Substantially Revised From the Proposed Section
451(b) Regulations
i. Application of the AFS Income Inclusion Rule to Multi-Year Contracts
The final regulations clarify how section 451(b) applies to multi-
year contracts. The Treasury Department and
[[Page 829]]
the IRS considered two alternative approaches for such contracts: (i)
An annual approach and (ii) a cumulative approach. Under an annual
approach, for each taxable year under the contract a taxpayer would
compare the amount of income taken into account as AFS revenue for that
taxable year and the amount of income that meets the requirements for
recognition under the all events test for that same taxable year to
determine its gross income inclusion for that taxable year; that is,
the taxpayer would include the larger of the two amounts. The total
amount of gross income recognized under the contract through the end of
such taxable year is not to exceed the total contract price.
In contrast, under a cumulative approach, in each taxable year a
taxpayer would compare the cumulative amount of revenue included in its
AFS up to and including that taxable year with the cumulative amount of
income that meets the requirements for recognition under the all events
test up to and including that taxable year. The taxpayer would then
take the larger of the two amounts and reduce it for any prior taxable
year income inclusions with respect to that item of gross income to
determine the amount that is required to be included in gross income in
the current taxable year.
The difference between the annual approach and the cumulative
approach are illustrated by the following example. In 2021, D, an
engineering services provider, enters into a non-severable contract
with a customer to provide engineering services through 2024 for a
total of $100x. Under the contract, D receives payments of $25x in each
calendar year of the contract. For its AFS, D reports $50x, $0, $20x,
and $30x of AFS revenue from the contract for 2021, 2022, 2023, and
2024, respectively. D has an enforceable right, as defined in Sec.
1.451-3(a)(9), to recover all amounts reported as AFS revenue through
the end of a given contract year if the customer were to terminate the
contract on the last day of such year. The $25x payment received for
2023 is an advance payment, as defined in Sec. 1.451-8(a)(1), because
$5x of the $25x payment is reported as AFS revenue for 2024. D uses the
full inclusion method for advance payments.
The accompanying table shows the treatment of gross income under
the two approaches.
----------------------------------------------------------------------------------------------------------------
2021 2022 2023 2024 Total
----------------------------------------------------------------------------------------------------------------
Payments........................ $25x $25x $25x $25x $100x
AFS Revenue..................... 50x 0x 20x 30x 100x
Gross Income (cumulative 50x 0x 25x 25x 100x
approach)......................
Gross Income (annual approach).. 50x 25x 25x 0x 100x
----------------------------------------------------------------------------------------------------------------
An annual approach could accelerate the recognition of taxable
income to a greater degree than what is reflected in revenue for AFS
purposes. In this example, such an approach would ignore in 2022 the
fact that cumulative AFS revenue of $50x had been recognized as taxable
gross income in 2021. Accordingly, the annual approach would require
that an additional $25x of income be recognized in 2022, since a
payment of that amount was received in that year. In effect, an annual
approach would accelerate the recognition of $25x from 2023 to 2022
relative to gross income recognition under the cumulative AFS income
inclusion rule.
The Treasury Department and IRS concluded that the extent of
acceleration of income that may occur when using an annual approach
would be excessive relative to the cumulative approach when considered
against the intent and purpose of the statute. The final regulations
therefore adopt the cumulative approach.
The Treasury Department and the IRS have not estimated the
difference in compliance costs, administrative burden, or economic
activity between the final regulations and an alternative regulatory
approach of using an annual comparison. The Treasury Department and the
IRS have not undertaken this estimation because they do not have
sufficiently detailed data or models that capture possible differences
in taxpayers' income inclusions under these two alternative regulatory
approaches.
ii. Applicable Financial Statement Covering a Group of Entities
The final regulations provide rules for taxpayers whose financial
results are included on an AFS covering a group of entities. These
rules specify that, if a taxpayer's financial results are reported on
the AFS for a group of entities, the taxpayer's AFS is the group's AFS.
However, if the taxpayer also reports financial results on a separate
AFS that is of equal or higher priority, then the separate AFS is the
taxpayer's AFS. The rules also specify how a taxpayer using a group AFS
is to determine the amount of revenue allocated to the taxpayer. The
Treasury Department and the IRS considered as an alternative not
providing substantive rules on how taxpayers should apply the AFS
income inclusion rule when their financial results are included in an
AFS for a group of entities. This alternative was rejected because it
would have increased compliance burdens and potentially led to
similarly situated taxpayers applying the AFS income inclusion rule
differently.
The Code does not specify how the AFS income inclusion rule is to
function whenever the AFS accounting period and the taxable year do not
coincide. The final regulations do not adopt a single, one-size-fits-
all approach, but rather provide taxpayers three separate options for
addressing this situation. A change from one option to another,
however, would be considered a change in method of accounting requiring
the permission of the IRS. By providing taxpayers with several options,
the final regulations will minimize taxpayer compliance costs when
dealing with non-congruent tax and financial accounting periods
relative to an alternative approach of specifying a single option, with
no significant revenue implications or effects on economic decisions.
iii. Revenue in an AFS
The final regulations describe and clarify the definition of AFS
revenue to broadly include amounts characterized as revenue in a
taxpayer's AFS as well as amounts reported in other comprehensive
income or retained earnings provided such amounts relate to an item of
gross income that is subject to the rules under section 451(b) and (c).
The Treasury Department and the IRS considered and rejected a narrower
definition of revenue or a definition that was tied to the AFS
definition of revenue. The definition of revenue advanced in the final
regulations is consistent with the current application of the all
events test under Sec. 1.451-1(a) and ensures that all relevant
financial statement items are taken into account for tax purposes. In
contrast, a narrow definition of revenue would allow, or even
encourage, taxpayers to avoid the AFS income inclusion rule by not
[[Page 830]]
classifying an item as revenue on their financial statement.
iv. Rules for Certain Debt Instruments
Section 451(b)(2) states that the AFS inclusion rule does not apply
to items of gross income for which a taxpayer uses a special method of
accounting provided under the Code. However, the Code does not apply
this exception to special accounting rules that apply to original issue
discount (OID), market discount, and certain other items with respect
to debt instruments under part V of Subchapter P of the Code.
The final regulations implement this provision by providing a non-
exhaustive list of special methods of accounting, and by clarifying how
section 451(b) applies to certain credit card receivables. The final
regulations specifically except from section 451(b) the timing rules
for accrued market discount on bonds and the general OID timing rules,
as well as the timing rules for OID determined with respect to special
debt instruments (contingent payment and variable rate debt
instruments, certain hedged debt instruments, and inflation-indexed
debt instruments). Nevertheless, following the legislative history of
the TCJA (see Conference Report, p. 276), the final regulations provide
that credit card late fees, credit card cash advance fees, and
interchange fees are subject to the AFS income inclusion rule. The
final regulations further specify that if these credit card fees are
subject to the AFS income inclusion rule, they are not to be taken into
account in determining whether a debt instrument associated with them
has OID. Existing rules continue to apply to these items for taxpayers
not possessing an AFS. The Treasury Department and the IRS expect that
this treatment will provide a straightforward application of section
451(b) consistent with Congressional intent without unnecessarily
complicating OID calculations and adding to taxpayer compliance
burdens.
The Treasury Department and the IRS considered and rejected a
broader application of the AFS income inclusion rule to include all
amounts determined under the OID and market discount accounting
methods, even in cases where the items are treated as discount or as an
adjustment to the yield of a debt instrument over the life of the
instrument in its AFS for financial reporting purposes. The final
regulations do not subject these amounts to the AFS income inclusion
rule because these special accounting methods do not generally rely on
the all events test to determine the timing of income inclusion and
these current special accounting methods provide workable income-
recognition timing rules that appropriately measure income. The
Treasury Department and the IRS expect that subjecting these items to
the AFS income inclusion rule of section 451(b) would disrupt and
complicate current tax accounting practices with no general economic
benefit.
5. Economic Effects of Provisions Under 451(c)
a. Provisions Substantially Revised From the Proposed Section 451(c)
Regulations
i. Cost Offset for Advance Payments
The Treasury Department and the IRS considered three options for
addressing the treatment of costs under section 451(c): (i) No cost
offset; (ii) a cost offset for incurred costs; and (iii) a cost offset
that further allowed for projected costs. The proposed section 451(c)
regulations (in this part C.5, proposed regulations) did not provide
for a cost offset for advanced payments. At the time, the Treasury
Department and the IRS argued that Congress intentionally simplified
the rules for advance payments by limiting the deferral of advance
payments for taxpayers with an AFS to a prescribed statutory method
that (1) does not include an accelerated cost offset, (2) is consistent
with Revenue Procedure 2004-34, and (3) overrides Sec. 1.451-5.
Taxpayers commenting on the proposed regulations were concerned that
the failure to provide a cost offset rule in 451(c) would cause a
mismatch of income and expenses and result in the taxation of gross
receipts. For example, if a business has a multi-year contract to build
or manufacture a highly customized good, it would report any advance
payment in income in the year of receipt or in the following taxable
year. If it uses the advance payment to purchase materials and to pay
workers as part of the project, it would recover those costs only when
the sale takes place. Under the proposed regulations, the statute would
generate a tax on the total amount of the advance payment in the first
years of the contract with all related costs being recovered later in
the contract.
In response to these comments on the proposed regulations, the
Treasury Department and the IRS have written the final regulations to
include an offset for cost of goods in progress (cost offset). This
cost offset allows taxpayers to reduce the amount of an advance payment
for the future sale of inventory that is required to be included in
gross income in a year prior to the year in which ownership of the
inventory is transferred to the customer. The amount of such reduction,
or cost offset, is equal to the inventoriable costs incurred as of the
end of the taxable year in which the advance payment is required to be
included in gross income under the taxpayer's method of accounting for
advance payments. This provision of the final regulations allows
taxpayers to offset advance payments included in income under either
the full inclusion method or the deferral method. However, the cost of
goods in progress offset cannot reduce the amount of the advance
payment income inclusion below zero. Any incurred costs subject to this
limitation may be carried forward to determine the cost of goods in
progress in subsequent taxable years.
The cost offset in the final regulations generally reduces the
amount of the advance payment that is required to be included in gross
income in a taxable year prior to the year in which ownership of the
inventory is transferred to the customer relative to the proposed
regulations. An improved match of income and cost timing is generally
held to provide a more accurate measure of economic activity and thus
provide a more efficient tax system than under the proposed
regulations. For further discussion of the economic effects of the cost
offset for advance payments and for income more generally see 4.a.i.
The Treasury Department and the IRS considered expanding the cost
offset to allow for projected costs, with several possible formats
being considered for how projected costs would be treated. Allowing an
offset for projected costs would entail a higher administrative burden
than the offset for incurred costs and may not definitively improve the
alignment of when income and costs are recognized for tax purposes
relative to the offset for incurred costs.
The Treasury Department and the IRS have not estimated the
difference in compliance costs, administrative burden, or income-cost
alignment (and any subsequent effects on economic activity) between the
final regulations and alternative regulatory approaches using projected
costs associated with advance payments. The Treasury Department and the
IRS have not undertaken this estimation because they do not have
sufficiently detailed data or models that capture possible differences
in cost offset formats that use incurred costs versus projected costs.
[[Page 831]]
b. Provisions Not Substantially Revised From the Proposed Regulations
i. Deferral Methods Under Section 451(c)
The statute prescribes a particular deferral method for accrual-
method taxpayers that have an AFS (AFS taxpayers) but does not
explicitly describe a deferral method to be used by taxpayers that do
not have an AFS (non-AFS taxpayers). To remedy this gap, the proposed
and final regulations describe and clarify that a method similar to the
deferral method available to non-AFS taxpayers under Revenue Procedure
2004-34 will be available to non-AFS taxpayers.
The Treasury Department and the IRS considered and rejected a
narrow interpretation of section 451(c) that would have precluded non-
AFS taxpayers from using a deferral method similar to that provided in
Revenue Procedure 2004-34. Section 451(c) does not explicitly prohibit
the use of such a method by non-AFS taxpayers, and the Treasury
Department and IRS continue to have authority under the Code to
prescribe a deferral method for such taxpayers. Precluding non-AFS
taxpayers from using a deferral method similar to that of AFS taxpayers
would treat AFS and non-AFS taxpayers quite differently regarding
business decisions they might make that are otherwise similar. Such
treatment would result in a less economically efficient tax system,
which generally treats similar economic decisions similarly.
ii. Advance Payment Acceleration Provisions
If a taxpayer ceases to exist by the close of a taxable year in
which an advance payment has been received and deferred, then issues
may arise as to when or whether the remaining amount of the payment
will be recognized as taxable income because there may not be a
succeeding taxable year in which such income can be recognized.
Under the statute, if the taxpayer dies or ceases to exist by the
close of the taxable year in which the advance payment was received,
any remaining untaxed amounts of advance payments must be included in
income in the year they were received. The final regulations extend
this payment ``acceleration'' rule to situations in which a performance
obligation is satisfied or otherwise ends in the taxable year of
receipt or in a succeeding short taxable year, a treatment that is
consistent with a similar rule in Revenue Procedure 2004-34.
The Treasury Department and the IRS considered not modifying or
expanding the acceleration rule contained in section 451(c) but
rejected this alternative because the remaining amount may never be
included in income, thus risking a permanent exclusion of the amount
from taxable income. The possibility of a permanent exclusion of income
provides incentives for taxpayers to structure payments in ways that
avoid tax liability, thus reducing Federal tax revenue without
providing an accompanying general economic benefit. The proposed and
final regulations treat the expanded set of accelerated transactions
consistently with similar types of transactions based on the timing and
structure of the payments involved.
iii. Advance Payments and Financial Statement Adjustments
Under the statute, if a taxpayer counts an advance payment as an
item of deferred revenue, under certain conditions (for example,
certain acquisitions of one corporation by another), the taxpayer may
be required by its system of accounting to adjust that item on the
balance sheet in a subsequent year. The item would then not be included
in current earnings or AFS revenues. In this case, taxpayers might
argue that they can exclude the amount deferred from taxable income
because it is never ``earned'' nor included in revenue under their AFS.
If this argument were upheld, taxpayers could convert an income
``deferral'' amount into an income ``exemption'' amount. To address
this issue and avoid this possibility, the proposed and final
regulations specify that such financial statement adjustments are to be
treated as ``revenue.''
The Treasury Department and the IRS considered not providing
clarity on the treatment of financial statement write-downs but
rejected that approach because it would have risked an inappropriate
permanent exclusion of income. The possibility of a permanent exclusion
of income provides incentives for taxpayers to structure payments in
ways that avoid tax liability, thus reducing Federal tax revenue
without providing an accompanying general economic benefit.
iv. Short Taxable Years and the 92-Day Rule
Section 451(c) does not provide a rule relating to the treatment of
short taxable years. In the absence of such a rule, it will be unclear
to taxpayers how they should implement the deferral method provided in
section 451(c) in the case of a short taxable year. To address this
issue, the proposed and final regulations provide rules relating to the
treatment of short taxable years for advance payments that are
generally consistent with Revenue Procedure 2004-34. The Treasury
Department and the IRS considered and rejected not providing short
taxable year rules because such a decision would have created
significant confusion among taxpayers, increased administrative costs
for the IRS, and increased compliance costs for taxpayers.
v. Performance Obligations for Non-AFS Taxpayers
A performance obligation is generally a contractual arrangement
with a customer to provide a good, service or a series of goods or
services that are basically the same and have a routine pattern of
transfer. Further, each performance obligation in a contract generally
yields a separate item of gross income. The Treasury Department and the
IRS interpret the statute as requiring taxpayers to allocate payments
attributable to multiple items of gross income in the same manner as
such payments are allocated to the corresponding performance
obligations in the taxpayer's AFS. The statute does not, however,
specify the allocation rules to be used by non-AFS taxpayers.
To address this issue, the proposed and final regulations provide
allocation rules for non-AFS taxpayers consistent with a similar rule
in Revenue Procedure 2004-34. That rule specifies that a payment that
is attributable to multiple items of gross income is required to be
allocated to such items in a manner that is based on objective
criteria. The objective criteria standard will be satisfied if the
allocation method is based on payments the taxpayer regularly receives
for an item or items that are regularly sold or provided separately.
The Treasury Department and the IRS considered not providing allocation
rules for non-AFS taxpayers but rejected such an approach because it
would have treated similarly situated taxpayers quite differently and
would have led to increased administrative costs for the IRS and
increased compliance costs for taxpayers relative to the rules provided
in the final regulations. While the allocation rules for AFS taxpayers
and non-AFS taxpayers differ to some degree under the final
regulations, the chosen provision provides a rule upon which non-AFS
taxpayers can rely, while minimizing the differences between AFS and
non-AFS taxpayers in this regard within the constraints imposed by the
statute.
[[Page 832]]
vi. Specified Good Exception
Section 451(c) provides that certain items are excluded from the
definition of an advance payment. Those items include rent; insurance
premiums governed by subchapter L; payments with respect to financial
instruments; payments with respect to certain warranty or guaranty
contracts; payments subject to section 871(a), 881, 1441, or 1442;
payments in property to which section 83 applies; and other payments
identified by the Secretary. This list of items excluded from the
definition of an advance payment is generally comparable to the list of
items excluded from the definition of an advance payment in Revenue
Procedure 2004-34.
Prior to release of the proposed regulations, several commenters
requested that the list of excluded items be expanded to include
certain goods that require a significant amount of capital to produce
and that may require considerable time from development to delivery.
Generally, for financial statement purposes, such manufacturers
recognize revenue related to these goods when the product is completed
and delivered and the title and risk of loss have transferred to the
customer.
To address this issue, the proposed regulations crafted a narrow
specified-goods exception for taxpayers who receive advance payments
but do not perform the work or deliver the good for several years in
the future. Specifically, an exclusion was introduced for certain goods
for which a taxpayer requires a customer to make an upfront payment
under the contract if (i) the contracted delivery month and year of the
good occurs at least two taxable years after an upfront payment, (ii)
the taxpayer does not have the good or a substantially similar good on
hand at the end of the year the upfront payment is received, and (iii)
the taxpayer recognizes all of the revenue from the sale of the good in
its AFS in the year of delivery.
The final regulations make one minor modification to the specified
good exception. In response to comments, the final regulations give
taxpayers the option to treat upfront payments that satisfy the
criteria for the specified good exception as a typical advance payment
under section 451(c). In other words, taxpayers have the option of
including the advance payment in gross income under the full inclusion
method or the deferral method. This flexibility in the section 451(c)
regime reduces uncertainty for taxpayers who may be unsure if a
contract meets the specified good exception relative to the proposed
regulations. It also allows taxpayers using the 1-year deferral under
Revenue Procedure 2004-34 prior to the passage of the TCJA the option
to continue to do so.
The Treasury Department and the IRS considered as an alternative
not using the authority granted to the Secretary in section
451(c)(4)(B)(vii) to exclude certain payments. For manufacturers of
highly customizable goods with a delivery date more than two years
after the upfront payment, the one-year deferral period has the
potential to increase book-tax accounting differences relative to the
final regulations. For some companies, a one-year deferral period may
require the creation of separate records to track advance payments for
accounting and tax purposes. Thus, for these taxpayers, the final
regulations may provide greater conformity between accounting (book)
income and taxable income to the extent that applicable case law would
defer the inclusion of income related to the specified goods exception.
II. Paperwork Reduction Act
These regulations do not impose any additional information
collection requirements in the form of reporting, recordkeeping
requirements or third-party disclosure requirements related to tax
compliance. Instead, because section 451(b) and section 451(c) and
these regulations provide various methods of accounting affecting the
timing of income inclusion, taxpayers without an existing method of
accounting for these items may initially adopt such method without the
consent of the Commissioner. However, the consent of the Commissioner
under section 446(e) and the accompanying regulations is required
before implementing method changes from one method to another method.
See Sec. Sec. 1.451-3(l) and 1.451-8(g). Some of the methods of
accounting referenced by and discussed in these regulations are
represented in the following chart.
------------------------------------------------------------------------
Section Brief description of method
------------------------------------------------------------------------
Sec. 1.451-3(b)(2)(i)...... Application of AFS income inclusion rule
by making all AFS revenue adjustments.
Sec. 1.451-3(b)(2)(ii)..... Application of AFS income inclusion rule
by making certain AFS revenue
adjustments (Alternative AFS Revenue
method).
Sec. 1.451-3(c)............ AFS cost offset method.
Sec. 1.451-3(i)(4)......... Computing revenue when the AFS and
taxable years are mismatched.
Sec. 1.451-3(l)............ Change in the method of recognizing
revenue in an AFS.
Sec. 1.451-8(c)............ Deferral method for taxpayers with an
AFS.
Sec. 1.451-8(d)............ Deferral method for taxpayer without an
AFS.
Sec. 1.451-8(e)............ Advance payment cost offset method.
Sec. 1.451-8(f)............ Election for the specified goods
exception to not apply.
Sec. 1.451-8(g)............ Change in the method for recognizing
advance payments on an AFS.
------------------------------------------------------------------------
Taxpayers request consent to use a method in these regulations by
filing Form 3115, Application for Change in Accounting Method (Parts I,
II, IV and Schedule B). Filing of Form 3115 and any statements attached
thereto (for taxpayers who are required to do so or who elect certain
methods of accounting described in the regulations) is the sole
collection of information requirement imposed by the statute and the
regulations.
For the Paperwork Reduction Act (PRA), the reporting burden
associated with the collections of information in these regulations
will be reflected in the IRS Form 3115 PRA Submissions (OMB control
numbers 1545-0074 for individual filers, 1545-0123 for business filers,
and 1545-2070 for all other types of filers).
In 2018, the IRS released and invited comment on a draft of Form
3115 to give the public the opportunity to benefit from certain
specific revisions made to the Code. The IRS received no comments on
the forms during the comment period. Consequently, the IRS made the
forms available in January 2019 for use by the public. Form 3115
applies to changes of accounting methods generally and is therefore
broader than section 451(b).
On November 25, 2019, the Treasury Department and the IRS published
Revenue Procedure 2019-43, 2019-28 I.R.B. 1107, which updated Revenue
Procedure 2018-31, and provides a
[[Page 833]]
global list of automatic method change procedures, including procedures
for taxpayers to comply with various provisions in section 451(b) and
(c) and the proposed regulations. Under the procedures, taxpayers can
request permission to change to a method of accounting to comply with
the various provisions in section 451(b) and (c) and the proposed
regulations using reduced filing requirements, such as by filing a
short Form 3115, or for certain taxpayers, by using a streamlined
method change procedure that involves not filing a Form 3115.
The current status of the PRA submissions that will be revised as a
result of the information collections in these regulations is provided
in the accompanying table. As described earlier, the reporting burdens
associated with the information collections in these regulations are
included in the aggregated burden estimates for OMB control numbers
1545-0074 (in the case of individual filers of Form 3115), 1545-0123
(in the case of business filers of Form 3115 and filers subject to
Revenue Procedure 2018-31). The overall burden estimates associated
with the OMB control numbers identified later are aggregate amounts
that relate to the entire package of forms associated with the
applicable OMB control number and will in the future include, but not
isolate, the estimated burden of the tax forms that will be created or
revised as a result of the information collections in these
regulations. These numbers are therefore unrelated to the future
calculations needed to assess the burden imposed by these regulations.
These burdens have been reported for other income tax regulations that
rely on the same information collections, and the Treasury Department
and the IRS urge readers to recognize that these numbers are duplicates
and to guard against overcounting the burdens imposed by tax provisions
prior to the TCJA.
No burden estimates specific to the forms affected by these
regulations are currently available. The Treasury Department and the
IRS have not estimated the burden, including that of any new
information collections, related to the requirements under these
regulations. For the OMB control numbers discussed in the preceding
paragraphs, the Treasury Department and the IRS estimate PRA burdens on
a taxpayer-type basis rather than a provision-specific basis. Those
estimates capture both changes made by the TCJA and those that arise
out of discretionary authority exercised in these regulations and other
regulations that affect the compliance burden for that form.
The Treasury Department and IRS request comment on all aspects of
information collection burdens related to these regulations, including
estimates for how much time it would take to comply with the paperwork
burdens described earlier for each relevant form and ways for the IRS
to minimize the paperwork burden. In addition, when available, drafts
of IRS forms are posted for comment at https://apps.irs.gov/app/picklist/list/draftTaxForms.htm. IRS forms are available at https://www.irs.gov/forms-instructions. Forms will not be finalized until after
they have been approved by OMB under the PRA.
----------------------------------------------------------------------------------------------------------------
Form/ revenue procedure Type of filer OMB no.(s) Status
----------------------------------------------------------------------------------------------------------------
Form 3115............................. All other Filers (mainly 1545-2070 Published in the Federal
trusts and estates) Register on 2/15/17. Public
(Legacy system). comment period closed on 4/
17/17.
-------------------------------------------------------------------------
Link: https://www.federalregister.gov/documents/2017/02/15/2017-02985/proposed-information-collection-comment-request.
-------------------------------------------------------------------------
Business (NEW Model)..... 1545-0123 Published in the Federal
Register on 10/8/18. Public
comment period closed on 12/
10/18.
-------------------------------------------------------------------------
Link: https://www.federalregister.gov/documents/2018/10/09/2018-21846/proposed-collection-comment-request-for-forms-1065-1065-b-1066-1120-1120-c-1120-f-1120-h-1120-nd.
-------------------------------------------------------------------------
Individual (NEW Model)... 1545-0074 Limited scope submission
(1040 only) on 10/11/18 at
OIRA for review. Full ICR
submission for all forms in
2019.
-------------------------------------------------------------------------
Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201808-1545-031 031.
----------------------------------------------------------------------------------------------------------------
Revenue Procedure 2018-31............. IRS Research estimates... 1545-0123 Published in the Federal
Register on 9/30/19. Public
Comment period closed on 12/
23/19.
-------------------------------------------------------------------------
Link: https://www.federalregister.gov/documents/2019/10/22/2019-23009/proposed-collection-comment-request-for-rev-proc-2018-31.
----------------------------------------------------------------------------------------------------------------
III. Regulatory Flexibility Act
Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it
is hereby certified that these regulations will not have a significant
economic impact on a substantial number of small entities within the
meaning of section 601(6) of the Regulatory Flexibility Act (small
entities). This certification can be made because the Treasury
Department and the IRS have determined that the regulations may affect
a substantial number of small entities but have also concluded that the
economic effect on small entities as a result of these regulations is
not expected to be significant. Section 451(b) requires that an item of
income be included in gross income for tax purposes no later than when
the item is counted as revenue in an AFS. Due to the revised financial
accounting standards for calculating revenue in an AFS under ASC 606,
the result of section 451(b) generally will be to move the recognition
of income forward by a year or two compared to previous law. Section
451(c) provides rules regarding the treatment of advance payments.
These regulations provide general guidance on the rules, including the
scope of the rules, exceptions to the rules, definitions of key terms,
and examples demonstrating applicability of the rules.
The Treasury Department and the IRS have estimated the number of
small
[[Page 834]]
business entities that may be affected by the statute and these
regulations. Section 451(b) and (c) and the regulations under Sec.
1.451-3 affect only those business entities that (i) use an accrual
method of accounting, and (ii) have an AFS. One provision in Sec.
1.451-8 applies to accrual method taxpayers without an AFS. The
remaining provisions in Sec. 1.451-8 apply to accrual method taxpayers
with an AFS.
Regarding the accrual method of accounting, section 13102 of TCJA
modified section 448 to expand the number of taxpayers eligible to use
the cash receipts and disbursements method of accounting (cash method
of accounting). In general, C corporations and partnerships with a C
corporation partner are now permitted to use the cash method of
accounting if average annual gross receipts are $25 million or less for
taxable years beginning in 2018 (up from $5 million or less in 2017).
The $25 million figure is considered for adjustment for inflation
annually. This amount was adjusted for inflation for taxable years
beginning after December 31, 2018. The amount was $26 million for
taxable year 2019. The Treasury Department and the IRS estimate that
approximately 3,128,000 business entities with gross receipts of $26
million or less used an accrual method of accounting in taxable year
2017, which represents approximately 8.5 percent of all business
entities with gross receipts of $26 million or less. The Treasury
Department and the IRS project that in future years, the number of
entities with gross receipts not greater than $26 million that will be
using the accrual method will be less than 8.5 percent of all entities
with gross receipts of $26 million or less.
Many small business entities use the cash method of accounting, as
opposed to an accrual method, and thus are not subject to these
regulations. The percent of returns that use an accrual method of
accounting, by entity types and for entities with gross receipts not
greater than $26 million, is shown in the accompanying table.
Total Returns and Returns Using Accrual Method of Accounting
[Taxable year 2017]
----------------------------------------------------------------------------------------------------------------
Entities with gross receipts not greater than $26 million
-----------------------------------------------------------------------------------------------------------------
Returns using
an accrual Percent of
Entity Total returns method of returns using
(thousands) accounting accrual method
(thousands) of accounting
----------------------------------------------------------------------------------------------------------------
C corporations.................................................. 1,570 691 44
S corporations.................................................. 4,684 1,146 24
Partnerships.................................................... 3,884 912 23
Sole proprietors and LLCs....................................... 26,425 379 1
-----------------------------------------------
All entities................................................ 36,425 3,128 8.5
----------------------------------------------------------------------------------------------------------------
Source: Internal Revenue Service, RAAS, KDA.
The Treasury Department and the IRS next examined the second
condition, that entities with an AFS are affected by section 451(b) and
the regulations. The Treasury Department and the IRS do not have
readily available data to measure the prevalence of entities with an
AFS, as defined in the statute and in Sec. 1.451-3(b)(1). However,
Schedule M-3, which is used to reconcile an entity's net income or loss
for tax purposes with its book income or loss, reports whether an
entity has a certified audited income statement. The Schedule M-3 is
required to be filed only by entities with at least $10 million of
assets. This population is more likely to possess an AFS and,
conversely, entities that do not file Schedule M-3 are less likely to
possess an AFS as owners and/or creditors of such smaller entities are
less likely to require the entity to certify its financial results via
a financial statement audit. Data is currently available only for
electronic filers.
For taxable year 2017, approximately 89 percent of accrual-method
entities filing Forms 1120, 1120-S, and 1065 with gross receipts of $26
million or less were filers of electronic tax forms. About 11 percent,
or 288,000 returns, included a Schedule M-3. About 40 percent of the
returns with Schedule M-3, or 113,000, indicated they had a certified
audited income statement. Based on the assumption that filers of paper
tax forms have the same incidence as electronic filers and that
entities that do not file a Schedule M-3 generally do not have an AFS,
then the Treasury Department and the IRS estimate that roughly 127,000
(113,000/0.89) entities with gross receipts of $26 million or less are
accrual-method entities that have an AFS. If 5 percent of entities that
do not file a Schedule M-3 also have an AFS then approximately 224,000
entities with gross receipts of $26 million or less are potentially
affected by these regulations. These estimates of affected filing
entities are reproduced in the following table.
Corporation and Partnership Returns Using An Accrual Method of Accounting--Taxable Year 2017
[Thousands of returns]
----------------------------------------------------------------------------------------------------------------
Entities with gross receipts not greater than $26 million
-----------------------------------------------------------------------------------------------------------------
E-filed Paper-filed
returns returns Total returns
----------------------------------------------------------------------------------------------------------------
Returns......................................................... 2,503 307 2,810
Returns with a Schedule M-3..................................... 288 * 35 * 323
Returns with a Schedule M-3 and an audited income statement..... 113 * 14 * 127
Returns without a Schedule M-3.................................. 2,215 * 272 * 2,487
Returns without a Schedule M-3, but with an audited income ** 111 ** 13 ** 124
statement......................................................
[[Page 835]]
Returns with an audited income statement........................ ** 224 ** 27 ** 251
----------------------------------------------------------------------------------------------------------------
* Estimates are obtained by assuming paper-filed returns are similar to e-filed returns as regards the incidence
of a filing entity having a Schedule M-3 and an audited income statement.
** Estimates are obtained by assuming that 5% of returns without a Schedule M-3 have an audited income
statement. This compares with approximately 40% of returns with a Schedule M-3 having such a statement.
Source: Non-italic entries are estimates taken from the IRS Research, Applied Analytics and Statistics KDA
Division using data from the Compliance Data Warehouse. The total number of accrual method returns of
corporations and partnerships differs slightly from that reported in the earlier table due to the use of
different data sources for the two estimates. Italicized entries are additional estimates obtained in the
manner indicated in the table notes.
This rule would not have a significant economic impact on small
entities affected. The costs to comply with these regulations are
reflected in modest reporting activities. Taxpayers needing to make
method changes pursuant to these regulations will be required to file a
Form 3115. The Treasury Department and the IRS have provided
streamlined procedures for certain taxpayers to change their method of
accounting to comply with section 451(b) and (c), and plan to provide
streamlined procedures for such taxpayers to change to the methods of
accounting described in these regulations. Under the streamlined
procedures, eligible taxpayers would either complete only a portion of
the Form 3115 or would not complete the Form 3115 at all to comply with
the guidance. The streamlined method change procedures are available to
taxpayers, other than a tax shelter, who satisfy the gross receipts
test under section 448(c) and for taxpayers making such a method change
which results in a zero section 481(a) adjustment. In addition,
contemporaneous with these regulations, the Treasury Department and the
IRS are issuing a streamlined procedure for taxpayers using a section
451(b) method who have a change in their AFS for revenue recognition
that requires a method change for tax purposes.
The estimated cumulative annual reporting and/or recordkeeping
burden for the statutory method changes relating to the streamlined
procedures used to be described under OMB control number 1545-1551. In
2019, OMB number 1545-1551 was merged into OMB number 1545-0123. The
estimated number of respondents, after taking into account the
streamlined procedures that are being issued is 28,046 respondents, and
a total annual reporting and/or recordkeeping burden of 34,279 hours.
The estimated annual burden per respondent/recordkeeper under OMB
control number 1545-0123 before publication of this revenue procedure
varies from \1/6\ hour to 8\1/2\ hours, depending on individual
circumstances, with an estimated average of 1\1/2\ hours. The estimated
monetized burden for compliance is $95 per hour. The estimated
cumulative annual reporting and/or recordkeeping burden for the method
changes described under OMB control number 1545-0123 after the revenue
procedure is accounted for is 28,046 respondents, and a total annual
reporting and/or recordkeeping burden is 34,279 hours. These burdens
are essentially unaffected by these regulations.
Accordingly, the Secretary certifies that the rule will not have a
significant economic impact on a substantial number of small entities.
Pursuant to section 7805(f), the notice of proposed rulemaking
preceding this final rule was submitted to the Chief Counsel for the
Office of Advocacy of the Small Business Administration for comment on
its impact on small business. No comments on the notice were received
from the Chief Counsel for the Office of Advocacy of the Small Business
Administration.
IV. Unfunded Mandates Reform Act
Section 202 of the Unfunded Mandates Reform Act of 1995 (UMRA)
requires that agencies assess anticipated costs and benefits and take
certain actions before issuing a final rule that includes any Federal
mandate that may result in expenditures in any one year by a state,
local, or tribal government, in the aggregate, or by the private
section, of $100 million in 1995 dollars, update annually for
inflation. This rule does not include any Federal mandate that may
result in expenditures by state, local, or tribal governments, or by
the private section in excess of that threshold.
V. Executive Order 13132: Federalism
Executive Order 13132 (entitled ``Federalism'') prohibits an agency
from publishing any rule that has federalism implications if the rule
either imposes substantial, direct compliance costs on state and local
governments, and is not required by statute, or preempts state law,
unless the agency meets the consultation and funding requirements of
section 6 of the Executive order. This final rule does not have
federalism implications and does not impose substantial direct
compliance costs on state and local governments or preempt state law
within the meaning of the Executive order.
VI. Congressional Review Act
The Administrator of the Office of Information and Regulatory
Affairs of the Office of Management and Budget has determined that this
is a major rule for purposes of the Congressional Review Act (5 U.S.C.
801 et seq.). Under 5 U.S.C. 801(a)(3), a major rule takes effect 60
days after the rule is published in the Federal Register.
Notwithstanding this requirement, 5 U.S.C. 808(2) allows agencies
to dispense with the requirements of 5 U.S.C. 801 when the agency for
good cause finds that such procedure would be impracticable,
unnecessary, or contrary to the public interest and the rule shall take
effect at such time as the agency promulgating the rule determines.
Pursuant to 5 U.S.C. 808(2), the Treasury Department and the IRS find,
for good cause, that a 60-day delay in the effective date is contrary
to the public interest.
Following the amendments to section 451(b) and (c) by the TCJA, the
Treasury Department and the IRS published the proposed regulations to
provide certainty to taxpayers. In particular, as demonstrated by the
wide variety of public comments in response to the proposed regulations
received,
[[Page 836]]
taxpayers continue to express uncertainty regarding the proper
application of the statutory rules under section 451(b) and (c). This
is especially the case for taxpayers in the manufacturing and retail
industries producing or reselling inventoriable goods because the final
regulations allow such taxpayers to more clearly reflect their income
for Federal income tax purposes compared to the approach of the
proposed regulations. An earlier effective date will allow taxpayers to
implement the final regulations earlier to take advantage of certain
provisions in the Coronavirus Aid, Relief, and Economic Security Act,
Public Law 116-136 (March 27, 2020) that were designed to enhance
liquidity, such as the 5-year net operating loss carryback provisions.
Consistent with Executive Order 13924 (May 19, 2020), the Treasury
Department and the IRS have therefore determined that an expedited
effective date of the final regulations would more appropriately
provide such critical businesses greater liquidity needed to remain
open or ``re-open by providing guidance on what the law requires.'' 85
FR 31353-54. Accordingly, the Treasury Department and the IRS have
determined that the rules in this Treasury decision will take effect on
the date of filing for public inspection in the Federal Register.
Drafting Information
The principal author of these regulations is Jo Lynn Ricks (Office
of the Associate Chief Counsel (Income Tax and Accounting)). Other
personnel from the Treasury Department and the IRS, including Kate
Abdoo, John Aramburu, James Beatty (formerly Income Tax and
Accounting), David Christensen, Alexa Dubert, Sean Dwyer, Peter Ford,
Christina Glendening, Anna Gleysteen, Charlie Gorham, Evan Hewitt,
William Jackson, Doug Kim, Tom McElroy, and Karla Meola, Office of the
Associate Chief Counsel (Income Tax and Accounting); and William E.
Blanchard, Charles Culmer, and Deepan Patel, Office of the Associate
Chief Counsel (Financial Institutions and Products), participated in
their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 is amended by adding
entries in numerical order for Sec. Sec. 1.451-3 and 1.451-8 to read,
in part, as follows:
Authority: 26 U.S.C. 7805.
* * * * *
Section 1.451-3 also issued under 26 U.S.C. 451(b)(1)(A)(ii),
(b)(3)(C) and 461(h).
Section 1.451-8 also issued under 26 U.S.C. 451(c)(2)(A), (3),
(4)(A)(iii), (4)(b)(vii), and 461(h).
* * * * *
0
Par. 2. Section 1.446-1 is amended by adding a parenthetical sentence
between the first and second sentences of paragraph (c)(1)(ii)(A) to
read as follows:
Sec. 1.446-1 General rule for methods of accounting.
* * * * *
(c) * * *
(1) * * *
(ii) * * *
(A) * * * (See Sec. 1.451-1 for rules relating to the taxable year
of inclusion.) * * *
0
Par. 3. Section 1.446-2 is amended by removing ``or'' at the end of
paragraph (a)(2)(i)(E), removing the period at the end of paragraph
(a)(2)(i)(F) and adding ``; or'' in its place, and adding paragraph
(a)(2)(i)(G) to read as follows:
Sec. 1.446-2 Method of accounting for interest.
(a) * * *
(2) * * *
(i) * * *
(G) Section 1.451-3(j) (special ordering rule for specified fees).
* * * * *
0
Par. 4. Section 1.451-1 is amended by:
0
a. Adding ``(all events test)'' to the end of the second sentence of
paragraph (a).
0
b. Redesignating paragraphs (b) through (g) as (d) through (i).
0
c. Adding new paragraphs (b) and (c).
The additions read as follows:
Sec. 1.451-1 General rule for taxable year of inclusion.
* * * * *
(b) Timing of income inclusion for accrual method taxpayers with an
applicable financial statement. For the timing of income inclusion for
taxpayers that have an applicable financial statement, as defined in
Sec. 1.451-3(b)(1), and that use an accrual method of accounting, see
section 451(b) and Sec. 1.451-3.
(c) Special rule for timing of income inclusion from advance
payments. For the timing of income inclusion for taxpayers that receive
advance payments, as defined in Sec. 1.451-8(a)(1), and that use an
accrual method of accounting, see section 451(c) and Sec. 1.451-8.
* * * * *
0
Par. 5. Section 1.451-3 is added to read as follows:
Sec. 1.451-3 Timing of income inclusion for taxpayers with an
applicable financial statement using an accrual method of accounting.
(a) Definitions. The following definitions apply for this section:
(1) AFS income inclusion amount. The term AFS income inclusion
amount means the amount of an item of gross income that is required to
be included in gross income under the AFS income inclusion rule in
paragraph (b)(1) of this section.
(2) AFS income inclusion rule. The term AFS income inclusion rule
has the meaning provided in paragraph (b)(1) of this section.
(3) AFS inventory inclusion amount. The term AFS inventory
inclusion amount has the meaning provided in paragraph (c)(2)(i)(A) of
this section.
(4) AFS revenue. The term AFS revenue means revenue reported in the
taxpayer's AFS. The characterization of an amount in the AFS is not
determinative of whether the amount is AFS revenue. For example, AFS
revenue can include amounts reported as other comprehensive income or
adjustments to retained earnings in an AFS. See paragraph (b) of this
section for adjustments to AFS revenue that may need to be made to
apply the rules of this section.
(5) Applicable financial statement (AFS). Subject to the rules in
paragraph (a)(5)(iv) of this section, the terms applicable financial
statement and AFS are synonymous and mean the taxpayer's financial
statement listed in paragraph (a)(5)(i) through (iii) of this section
that has the highest priority, including priority within paragraphs
(a)(5)(i)(B) and (a)(5)(ii)(B) of this section. The financial
statements are, in order of descending priority:
(i) GAAP statements. A financial statement that is certified as
being prepared in accordance with United States generally accepted
accounting principles (GAAP) and is:
(A) A Form 10-K (or successor form), or annual statement to
shareholders, filed with the United States Securities and Exchange
Commission (SEC);
(B) An audited financial statement of the taxpayer that is used
for:
(1) Credit purposes;
(2) Reporting to shareholders, partners, or other proprietors, or
to beneficiaries; or
[[Page 837]]
(3) Any other substantial non-tax purpose; or
(C) A financial statement, other than a tax return, filed with the
Federal Government or any Federal agency, other than the SEC or the
Internal Revenue Service (IRS);
(ii) IFRS statements. A financial statement that is certified as
being prepared in accordance with international financial reporting
standards (IFRS) and is:
(A) Filed by the taxpayer with an agency of a foreign government
that is equivalent to the SEC, and has financial reporting standards
not less stringent than the standards required by the SEC;
(B) An audited financial statement of the taxpayer that is used
for:
(1) Credit purposes;
(2) Reporting to shareholders, partners, or other proprietors, or
to beneficiaries; or
(3) Any other substantial non-tax purpose; or
(C) A financial statement, other than a tax return, filed with the
Federal Government, Federal agency, a foreign government, or agency of
a foreign government, other than the SEC, IRS, or an agency that is
equivalent to the SEC or the IRS; or
(iii) Other statements. A financial statement, other than a tax
return, filed with the Federal Government or any Federal agency, a
state government or state agency, or a self-regulatory organization
including, for example, a financial statement filed with a state agency
that regulates insurance companies or the Financial Industry Regulatory
Authority. Additional financial statements beyond those included in
this paragraph (a)(5)(iii) may be provided in guidance published in the
Internal Revenue Bulletin (see Sec. 601.601(d) of this chapter).
(iv) Additional rules for determining priority. If a taxpayer
restates AFS revenue for a taxable year prior to the date that the
taxpayer files its Federal income tax return for such taxable year, the
restated AFS must be used instead of the original AFS. If using the
restated AFS revenue results in a change in method of accounting, the
preceding sentence applies only if the taxpayer receives permission to
change its method of accounting to use the restated AFS revenue. In
addition, if a taxpayer with different financial accounting and taxable
years is required to file both annual financial statements and periodic
financial statements covering less than a year with a government or
government agency, the taxpayer must prioritize the annual financial
statement in accordance with this paragraph (a)(5).
(6) Cost of goods. The term cost of goods means the costs that are
properly capitalized and included in inventory under sections 471 and
263A or any other applicable provision of the Internal Revenue Code
(Code) and that are allocable to an item of inventory for which an AFS
inventory inclusion amount is calculated. See paragraph (c)(5)(iii) of
this section for specific rules for taxpayers using simplified methods
under section 263A.
(7) Cost of goods in progress offset. The term cost of goods in
progress offset has the meaning provided in paragraph (c)(3) of this
section.
(8) Cumulative cost of goods in progress offset. The term
cumulative cost of goods in progress offset means the cumulative cost
of goods in progress offset amounts under paragraph (c) of this section
for a specific item of inventory that have reduced an AFS inventory
inclusion amount attributable to such item of inventory in prior
taxable years.
(9) Enforceable right. The term enforceable right means any right
that a taxpayer has under the terms of a contract or under applicable
Federal, state, or international law, including rights to amounts
recoverable in equity and liquidated damages. A contract can include,
but is not limited to, a statement of work, purchase order, or invoice.
(10) Equity method. The term equity method means a method of
accounting for financial accounting purposes under which an investment
is initially recorded at cost and subsequently increased or decreased
in carrying value by the investor's proportionate share of income and
losses and such income or losses are reported as separate items on the
investor's statement of income.
(11) Performance obligation. The term performance obligation means
a promise in a contract with a customer to transfer to the customer a
distinct good, service, or right; or a series of distinct goods,
services, or rights, or a combination thereof, that are substantially
the same and that have the same pattern of transfer to the customer. A
performance obligation includes a promise to grant or transfer a right
to use or access intangible property. Performance obligations in a
contract are identified by applying the accounting standards the
taxpayer uses to prepare its AFS. Additionally, to the extent the
contract with the customer provides the taxpayer with an enforceable
right to payment, the revenue from which is not allocated to a
performance obligation described in the first two sentences of this
paragraph (a)(11) in the taxpayer's AFS but is accounted for as a
separate source of revenue in the taxpayer's AFS, such right shall be
treated as a separate performance obligation under this section. A fee
described in paragraph (j)(2) of this section is an example of an
enforceable right that is treated as a separate performance obligation.
(12) Prior income inclusion amounts. The term prior income
inclusion amounts means amounts of an item of gross income that were
required to be included in the taxpayer's gross income under this
section or Sec. 1.451-8 in prior taxable years.
(13) Special method of accounting. The term special method of
accounting means a method of accounting expressly permitted or required
under any provision of the Code, the regulations in this part, or other
guidance published in the Internal Revenue Bulletin (see Sec.
601.601(d) of this chapter) under which the time for taking an item of
gross income into account in a taxable year is not determined under the
all events test in Sec. 1.451-1(a). See, however, paragraph (j) of
this section relating to certain items of income for debt instruments.
The term special method of accounting does not include any method of
accounting expressly permitted or required under this section. The
following are examples of special methods of accounting to which the
AFS income inclusion rule does not apply:
(i) The crop method of accounting under sections 61 and 162;
(ii) Methods of accounting provided in sections 453 through 460;
(iii) Methods of accounting for notional principal contracts under
Sec. 1.446-3;
(iv) Methods of accounting for hedging transactions under Sec.
1.446-4;
(v) Methods of accounting for REMIC inducement fees under Sec.
1.446-6;
(vi) Methods of accounting for gain on shares in a money market
fund under Sec. 1.446-7;
(vii) Methods of accounting for certain rental payments under
section 467;
(viii) The mark-to-market method of accounting under section 475;
(ix) Timing rules for income and gain associated with a transaction
that is integrated under Sec. 1.988-5, and income and gain under the
nonfunctional currency contingent payment debt instrument rules in
Sec. 1.988-6;
(x) Except as otherwise provided in paragraph (j) of this section,
timing rules for original issue discount (OID) under section 811(b)(3)
or 1272 (and the regulations in this part under section 1272 of the
Code), income under the contingent payment debt instrument rules in
Sec. 1.1275-4, income under the
[[Page 838]]
variable rate debt instrument rules in Sec. 1.1275-5, income and gain
associated with a transaction that is integrated under Sec. 1.1275-6,
and income under the inflation-indexed debt instrument rules in Sec.
1.1275-7;
(xi) Timing rules for de minimis OID under Sec. 1.1273-1(d) and
for de minimis market discount (as defined in section 1278(a)(2)(C));
(xii) Timing rules for accrued market discount under sections 1276
and 1278(b);
(xiii) Timing rules for short-term obligations under sections 1281
through 1283;
(xiv) Timing rules for stripped bonds under section 1286; and
(xv) Methods of accounting provided in sections 1502 and 1503 and
the regulations thereunder, including the method of accounting relating
to intercompany transactions under Sec. 1.1502-13.
(14) Transaction price amount. The term transaction price amount
means the total amount of consideration to which a taxpayer is, or
expects to be, entitled from all performance obligations under a
contract. The transaction price amount is determined under the
standards the taxpayer uses to prepare its AFS.
(b) AFS income inclusion rule--(1) In general. Except as otherwise
provided in this section, if a taxpayer uses an accrual method of
accounting for Federal income tax purposes and has an AFS, the all
events test under Sec. 1.451-1(a) for any item of gross income, or
portion thereof, is met no later than when that item, or portion
thereof, is taken into account as AFS revenue (AFS income inclusion
rule). See paragraph (b)(2) of this section for rules regarding when an
item of gross income, or portion thereof, is treated as taken into
account as AFS revenue under the AFS income inclusion rule. See
paragraph (c) of this section for optional rules to determine the AFS
income inclusion amount for an item of gross income from the sale of
inventory. See paragraph (d) of this section for rules regarding the
allocation of the transaction price amount to multiple items of gross
income. See paragraph (e) of this section for rules to determine the
AFS income inclusion amount for an item of gross income from a multi-
year contract. See paragraphs (f) and (g) of this section for
limitations of the AFS income inclusion rule. See paragraph (h) of this
section for special rules that may affect the determination of AFS
revenue under the AFS income inclusion rule. See paragraph (j) of this
section for special ordering rules for certain items of income with
respect to debt instruments.
(2) Amounts taken into account as AFS revenue--(i) General rule.
Unless the taxpayer uses the alternative AFS revenue method described
in paragraph (b)(2)(ii) of this section, the amount of the item of
gross income that is treated as taken into account as AFS revenue under
paragraph (b)(1) of this section is determined by making adjustments to
AFS revenue for the amounts described in paragraphs (b)(2)(i)(A)
through (D) of this section.
(A) If AFS revenue reflects a reduction for amounts described in
paragraph (b)(2)(i)(A)(1) or (2) of this section, AFS revenue is
increased by the amount of the reduction.
(1) Cost of goods sold and liabilities that are required to be
accounted for under other provisions of the Code such as section 461,
including liabilities for allowances, rebates, chargebacks, rewards
issued in credit card transactions and other reward programs, and
refunds, regardless of when any amount described in this paragraph
(b)(2)(i)(A)(1) is incurred.
(2) Amounts anticipated to be in dispute or anticipated to be
uncollectable.
(B) If AFS revenue includes an amount the taxpayer does not have an
enforceable right to recover if the customer were to terminate the
contract on the last day of the taxable year (regardless of whether the
customer actually terminates the contract), AFS revenue is reduced by
such amount.
(C) If the transaction price was increased because a significant
financing component is deemed to exist under the standards the taxpayer
uses to prepare its AFS, then any AFS revenue attributable to such
increase is disregarded.
(D) AFS revenue may be increased or reduced by additional amounts
as provided in guidance published in the Internal Revenue Bulletin (see
Sec. 601.601(d) of this chapter).
(ii) Alternative AFS revenue method. A taxpayer that chooses to
apply the AFS income inclusion rule by using the alternative AFS
revenue method described in this paragraph (b)(2)(ii) in lieu of the
rules in paragraph (b)(2)(i) of this section, determines the amount of
the item of gross income that is treated as taken into account as AFS
revenue under paragraph (b)(1) of this section by making adjustments to
AFS revenue for only the amounts described in paragraphs (b)(2)(i)(A),
(C), and (D) of this section. A taxpayer that uses the alternative AFS
revenue method for a trade or business must apply the method to all
items of gross income in the trade or business that are subject to the
AFS income inclusion rule.
(3) Exceptions. The AFS income inclusion rule in paragraph (b)(1)
of this section does not apply to:
(i) Any item of gross income, or portion thereof, if the timing of
income inclusion for that item, or portion thereof, is determined using
a special method of accounting;
(ii) Any item of gross income, or portion thereof, in connection
with a mortgage servicing contract; or
(iii) Any taxable year that is not covered for the entire year by
one or more AFS.
(4) Examples. The following examples illustrate the provisions of
paragraph (b) of this section. Unless the facts specifically state
otherwise, the taxpayer has an AFS, is on a calendar year for Federal
income tax purposes and AFS purposes, and uses an accrual method of
accounting for Federal income tax purposes. Further, the taxpayer does
not use the alternative AFS revenue method under paragraph (b)(2)(ii)
of this section or the AFS cost offset method under paragraph (d) of
this section, and does not use a special method of accounting:
(i) Example 1: Provision of installation services--(A) Facts. In
2021, B enters into a 2-year service contract with a customer to
install the customer's manufacturing equipment for $100,000. Throughout
the term of the contract, the customer retains control of the
equipment. B begins providing the installation services in 2021 and
completes the installation services in 2022. Under the contract, B
bills the customer $55,000 in 2021 when installation begins, but does
not have a fixed right to receive the remaining $45,000 until
installation is complete and approved by the customer. However, if the
customer were to terminate the contract prior to completion, B would
have an enforceable right to payment for all services performed prior
to the termination date. For its AFS, B reports $60,000 of AFS revenue
for 2021 and $40,000 of AFS revenue for 2022, in accordance with the
services performed in each respective year.
(B) Analysis. Under the all events test in Sec. 1.451-1(a), B is
required to include $55,000 in gross income in 2021 as B has a fixed
right to receive $55,000 as of the end of 2021. However, under the AFS
income inclusion rule, because B has an enforceable right to recover
the entire $60,000 that was reported in AFS revenue for 2021 had the
customer terminated the contract on the last day of 2021, the entire
$60,000 is treated as taken into account as AFS revenue in 2021.
Accordingly, the all events test is
[[Page 839]]
met for the $60,000 of gross income no later than the end of 2021 and B
is required to include $60,000 in gross income in 2021.
(ii) Example 2: Provision of goods included in AFS with enforceable
right--(A) Facts. In November 2021, C enters into a contract with a
customer to provide 50 customized computers for $80,000. Under the
contract, C can bill $80,000 after the customer accepts delivery of the
computers. However, the contract provides that C has an enforceable
right to be paid for work performed to date if the customer were to
terminate the contract prior to delivery. C produces and ships all of
the computers in 2021. In 2022, the customer accepts delivery of the
computers and C bills the customer. For its AFS, C reports $80,000 of
AFS revenue for 2021.
(B) Analysis. Under the all events test in Sec. 1.451-1(a), C does
not have a fixed right to receive the $80,000 until the customer
accepts delivery of the computers in 2022. However, under the AFS
income inclusion rule, because C has an enforceable right to recover
the entire $80,000 of AFS revenue that was reported for 2021 had the
customer terminated the contract on the last day of 2021, the entire
$80,000 is treated as ``taken into account as AFS revenue'' in 2021.
Accordingly, the all events test is met for the $80,000 no later than
in 2021 and C is required to include $80,000 in gross income in 2021.
(iii) Example 3: Provision of services included in AFS with
enforceable right--(A) Facts. In 2021, D, an engineering services
provider, enters into a 4-year contract with a customer to provide
services for a total of $100x. Under the contract, D bills and receives
$25x for each year of the contract. If the customer were to terminate
the contract prior to completion, D has an enforceable right to only
the billed amounts. For its AFS, D reports $60x, $0, $20x, and $20x of
AFS revenue from the contract for 2021, 2022, 2023, and 2024,
respectively.
(B) Analysis. Under the all events test in Sec. 1.451-1(a), D is
required to include $25x in gross income in 2021 as D has a fixed right
to receive $25x as of the end of 2021. Although D reports $60x of AFS
revenue from the provision of services for 2021, D has an enforceable
right to recover only $25x if the customer were to terminate the
contract on the last day of 2021. Accordingly, pursuant to paragraph
(b)(2)(i)(B) of this section, of the $60x of AFS revenue reported for
2021, only $25x is treated as ``taken into account as AFS revenue''
under the AFS income inclusion rule. As a result, D is required to
include only $25x in gross income in 2021. Similarly, in 2022, 2023 and
2024, D includes in gross income only the yearly $25x contract payments
under the all events test as only the billed amounts are treated as
``taken into account as AFS revenue'' under the AFS income inclusion
rule.
(iv) Example 4: Sale of good under cost-plus contract--(A) Facts.
In 2021, E, a manufacturer, enters into a contract with Fire Department
for the manufacture and delivery of a fire truck. The fire truck takes
10 months to manufacture at an estimated cost of $60,000. The contract
provides E with an enforceable right to recover costs incurred in
manufacturing the fire truck regardless of whether the Fire Department
accepts delivery of the fire truck or terminates the contract, and an
enforceable right to an additional $20,000 if the fire truck is
accepted by the Fire Department. E does not have an enforceable right
to recover any portion of the additional $20,000 if the Fire Department
were to terminate the contract before it accepts the fire truck. E has
an obligation to cure any defects if the customer rejects the fire
truck. In August 2021, E begins manufacturing the fire truck ordered by
Fire Department and incurs $30,000 of costs for materials and labor for
the contract. For its AFS, E reports $40,000 of AFS revenue for 2021
($30,000 costs plus $10,000 expected profit on the sale of the fire
truck).
(B) Analysis for 2021 taxable year. Under the all events test in
Sec. 1.451-1(a), E is required to include $30,000 in gross income in
2021 as E has a fixed right to receive $30,000 as of the end of 2021.
Although E reports $40,000 of AFS revenue for 2021, E has an
enforceable right to recover only $30,000 if the Fire Department were
to terminate the contract on the last day of 2021. Accordingly,
pursuant to paragraph (b)(2)(i)(B) of this section, of the $40,000 of
AFS revenue reported for 2021, only $30,000 is treated as ``taken into
account as AFS revenue'' under the AFS income inclusion rule. As a
result, E is required to include only $30,000 in gross income in 2021.
(v) Example 5: Sale of goods with AFS revenue adjustments--(A)
Facts. In July 2021, F, a manufacturer of automobile parts, enters into
a contract to sell 1,000 parts to a customer for $10 per part, for a
total of $10,000 (1,000 x $10). The contract also provides that F will
receive a $200 bonus if it delivers all the parts to the customer by
February 1, 2022. F delivers 500 non-defective parts to the customer on
December 31, 2021 and schedules the remaining 500 parts for delivery to
the customer on January 1, 2022. F does not have an enforceable right
to recover any portion of the $200 bonus if the customer were to
terminate the contract before all 1,000 parts are delivered. F expects
to earn the $200 bonus and have 5% of the non-defective parts returned.
For its AFS, F reports $4,850 ($5,000 + $100-$250) of AFS revenue for
2021, which includes a $100 (50% x $200) adjustment to increase AFS
revenue for the expected bonus and a $250 (5% x $5,000) adjustment to
decrease AFS revenue for anticipated returns.
(B) Analysis. Under the all events test in Sec. 1.451-1(a), F is
required to include $5,000, less the corresponding cost of goods sold
under sections 263A and 471 as applicable, in gross income in 2021 as F
has a fixed right to receive $5,000 from the delivery of 500 parts to
the customer in 2021. However, F does not have a fixed right to receive
any portion of the $200 delivery bonus as of the end of 2021 as the
remaining 500 parts had yet to be delivered. Under the AFS income
inclusion rule and, specifically, paragraphs (b)(2)(i)(A)(1) and
(b)(2)(i)(B) of this section, the amount treated as ``taken into
account as AFS revenue'' for 2021 is also $5,000, calculated as $4,850
of AFS revenue that was reported for 2021, decreased by $100 for the
expected delivery bonus that F does not have an enforceable right to
recover if the customer were to terminate the contract as of the end of
2021 and increased by $250 for anticipated return liabilities that are
accounted for under section 461 ($4,850-$100 + $250 = $5,000).
Accordingly, F is required to include $5,000, less the corresponding
cost of goods sold determined under sections 263A and 471 as
applicable, in gross income in 2021.
(vi) Example 6: Chargebacks--(A) Facts. In November 2021, G, a
pharmaceutical manufacturer, enters into a contract to sell 1,000 units
to W, a wholesaler, for $10 per unit, totaling $10,000 (1,000 x $10).
The contract also provides that G will credit or pay W $4 per unit (a
40% ``chargeback'') for sales W makes to certain qualifying customers.
G delivers 600 units to W on December 31, 2021, and bills W $6,000
under the contract. W does not make any sales to qualifying customers
in 2021. For its AFS, G reports $3,600 ($6,000-$2,400) of AFS revenue
for 2021, which includes a reduction of the $6,000 of sales revenue by
$2,400 (40% x $6,000) for anticipated chargebacks.
(B) Analysis. Under the all events test in Sec. 1.451-1(a), G is
required to include $6,000, less the corresponding cost of goods sold
under sections 263A and 471 as applicable, in gross income in 2021 as G
has a fixed right to receive $6,000
[[Page 840]]
from the delivery of 600 units to W in 2021. The anticipated
chargebacks are liabilities that are accounted for under section 461.
Under the AFS income inclusion rule and, specifically, paragraph
(b)(2)(i)(A)(1) of this section, the amount treated as ``taken into
account as AFS revenue'' for 2021 is also $6,000, calculated as $3,600
of AFS revenue reported for 2021, increased by $2,400 of anticipated
chargeback liabilities that are accounted for under section 461 ($3,600
+ $2,400 = $6,000). Accordingly, G is required to include $6,000, less
the corresponding cost of goods sold under sections 263A and 471 as
applicable, in gross income in 2021.
(vii) Example 7: Sale of property using a special method of
accounting. In 2021, H, a financial services provider, sells a building
for $100,000, payable in five annual payments of $20,000 together with
adequate stated interest, starting in 2021. For its AFS, H reports
$100,000 of AFS revenue for 2021 from the sale of the building. For
Federal income tax purposes, H uses the installment method under
section 453 for the sale of the building. Because the installment
method under section 453 is a special method of accounting under
paragraphs (a)(13)(ii) and (b)(3)(i) of this section, the AFS income
inclusion rule does not apply to H's sale of the building. Accordingly,
the gain from the sale is included in income as prescribed in section
453.
(viii) Example 8: Insurance contract renewals--(A) Facts. J, an
insurance agent, is engaged by an insurance carrier to sell insurance.
Pursuant to the contract between J and the insurance carrier, J is
entitled to receive a $50 commission from the insurance carrier at the
time a policy is sold to a customer. The contract also provides that J
is entitled to receive an additional $25 commission each time a policy
is renewed. J does not have an enforceable right to a renewal
commission if the insurance carrier terminates the contract before a
policy is renewed. J sells 1,000 one-year policies in 2021, of which
800 are expected to be renewed in 2022 and 700 are expected to be
renewed in 2023. J does not have any ongoing obligation to provide
additional services to the insurance carrier or the customers after the
initial sale of the policy. For its AFS, J reports $87,500 of AFS
revenue for 2021, which includes $50,000 ($50 x 1,000) of commission
income for policies sold in 2021 and an estimate of $37,500 ($25 x
1,500) of commission income for the policies expected to be renewed in
2022 and 2023.
(B) Analysis. Under the all events test in Sec. 1.451-1(a), J is
required to include $50,000 in gross income in 2021 as J has a fixed
right to receive $50,000 of commission income for the policies it sold
during 2021. However, as of the end of 2021, J does not have a fixed
right to receive any commission income from anticipated policy
renewals. Under the AFS income inclusion rule, although J reports
$87,500 of AFS revenue for 2021, J does not have an enforceable right
to recover the $37,500 of anticipated commission income from future
policy renewals if the insurance carrier were to terminate the contract
on the last day of 2021. Accordingly, pursuant to paragraph
(b)(2)(i)(B) of this section, of the $87,500 of AFS revenue reported
for 2021, only $50,000 is treated as ``taken into account as AFS
revenue'' under the AFS income inclusion rule. As a result, J is
required to include $50,000 in gross income in 2021. Alternatively, if
J uses the alternative AFS revenue method in paragraph (b)(2)(ii) of
this section, all $87,500 of AFS revenue reported for 2021 would be
treated as ``taken into account as AFS revenue'' under the AFS income
inclusion rule and J would be required to include $87,500 of commission
income in gross income in 2021.
(ix) Example 9: Escalating rents--(A) Facts. (1) K is a landlord in
the business of leasing office space. On January 1, 2021, K enters into
a 5-year lease with a tenant that provides for annual rent of $30,000
for 2021 and increases by 5% each year over the lease term. The annual
rents are due at the end of each year. Accordingly, the rent for each
year (rounded to the nearest dollar) is as follows:
Table 1 to Paragraph (b)(4)(ix)(A)
------------------------------------------------------------------------
Year Calculation Total rent
------------------------------------------------------------------------
2021................................ $30,000 $30,000
2022................................ 30,000 * 1.05 31,500
2023................................ 31,500 * 1.05 33,075
2024................................ 33,075 * 1.05 34,729
2025................................ 34,729 * 1.05 36,465
-----------------------------------
Total Rent for Five Years....... .................. 165,769
------------------------------------------------------------------------
(2) The lease is not a section 467 rental agreement as defined
under section 467(d). If the tenant terminates the lease early, the
tenant must pay K the balance of the rent due for the remainder of the
termination year. On its AFS, K reports AFS revenue from rents on a
straight-line basis over the term of the lease, or approximately
$33,154 per year ($165,769 total rent/5 years). Accordingly, for its
AFS, K reports $33,154 of AFS revenue for 2021.
(B) Analysis. Under the all events test in Sec. 1.451-1(a), K is
required to include $30,000 in gross income in 2021 as K has a fixed
right to receive $30,000 for the 2021 rental period under the terms of
the lease agreement. Under the AFS income inclusion rule, although K
reports $33,154 of AFS revenue for 2021, K has an enforceable right to
recover only $30,000 if the tenant were to cancel the lease on the last
day of 2021. Accordingly, pursuant to paragraph (b)(2)(i)(B) of this
section, of the $33,154 of AFS revenue reported for 2021, only $30,000
is treated as ``taken into account in AFS revenue'' under the AFS
income inclusion rule. As a result, K is required to include $30,000 in
gross income in 2021.
(x) Example 10: Licensing income from digital services--(A) Facts.
M is engaged in the business of licensing media entertainment content
packages. M licenses content packages to customers by entering into
subscription plans with customers. In January 2021, M enters into a
two-year subscription plan with Customer. M charges Customer $40 per
month billed monthly in arrears. If Customer terminates the plan prior
to the two-year term, it must pay the balance of the subscription fee
for the remaining term of the contract. For its AFS, M reports $960
($40 x 24 months) of AFS revenue for 2021.
(B) Analysis. Under the all events test in Sec. 1.451-1(a), M is
required to include $480 in gross income in 2021 as M has a fixed right
to receive $480 ($40 x 12) for the 12 months of media content licensed
to Customer in 2021. M does
[[Page 841]]
not have a fixed right to receive any portion of the 2022 subscription
fee as of the end of 2021 as such fee is not due under the terms of the
subscription agreement until 2022 and M has yet to provide the media
content for the 2022 subscription period. However, under the AFS income
inclusion rule, because M has an enforceable right to recover all $960
of AFS revenue reported for 2021 if Customer were to terminate the
contract at the end of 2021, all $960 is treated as ``taken into
account as AFS revenue'' in 2021. Accordingly, M is required to include
$960 in gross income in 2021.
(c) Cost offsets--(1) In general. This paragraph (c) provides an
optional method of accounting that may be used to determine the AFS
income inclusion amount for an item of gross income from the sale of
inventory (AFS cost offset method). A taxpayer that uses the AFS cost
offset method for a trade or business must apply this method to all
items of gross income in the trade or business that meet the criteria
in this paragraph (c). Additionally, a taxpayer that uses this method
for a trade or business must also use the advance payment cost offset
method described in Sec. 1.451-8(e) to account for all advance
payments received by such trade or business that meet the criteria in
Sec. 1.451-8(e), if applicable. A taxpayer that uses the AFS cost
offset method to account for gross income from the sale of an item of
inventory, but not the advance payment cost offset method because it
does not receive any advance payments for such item, determines the
corresponding AFS income inclusion amount for a taxable year by
following the rules in paragraph (c)(2) of this section. A taxpayer
that uses the AFS cost offset method and the advance payment cost
offset method to account for gross income, including advance payments,
from the sale of an item of inventory, determines the corresponding AFS
income inclusion amount and the advance payment income inclusion
amount, as defined in Sec. 1.451-8(a)(2), for a taxable year by
following the rules in paragraph (c)(2) of this section rather than the
rules under Sec. 1.451-8(e). However, if all payments received for the
sale of an item of inventory meet the definition of an advance payment
under Sec. 1.451-8(a)(1), a taxpayer that uses the advance payment
cost offset method determines the corresponding advance payment income
inclusion amount for a taxable year by following the rules in Sec.
1.451-8(e).
(2) AFS cost offset method. A taxpayer that uses the AFS cost
offset method and, if applicable, the advance payment cost offset
method, to account for gross income from the sale of an item of
inventory determines the AFS income inclusion amount, or, if
applicable, the advance payment income inclusion amount, for a taxable
year prior to the taxable year in which ownership of the item of
inventory is transferred to the customer by following the rules in
paragraph (c)(2)(i) of this section, subject to the additional rules
and limitations in paragraphs (c)(4) through (6) of this section. Such
taxpayer determines the AFS income inclusion amount or, if applicable,
the advance payment income inclusion amount, for the taxable year in
which ownership of the item of inventory is transferred to the customer
by following the rules in paragraph (c)(2)(ii) of this section. A
taxpayer described in this paragraph (c)(2) that receives advance
payments for the sale of the item of inventory may be required to
include in gross income for a taxable year an amount that is comprised
of both an AFS income inclusion amount and an advance payment income
inclusion amount. In such case, it is not necessary to determine the
portion of the total inclusion that is comprised of the AFS income
inclusion amount and the portion of the total inclusion that is
comprised of the advance payment income inclusion amount.
(i) Determining gross income for a year prior to the year of sale.
To determine the amount required to be included in gross income from
the sale of an item of inventory for a taxable year prior to the
taxable year in which ownership of the item of inventory is transferred
to the customer, a taxpayer must first determine the AFS inventory
inclusion amount for such item for such year by applying the steps in
paragraph (c)(2)(i)(A) of this section. This AFS inventory inclusion
amount is then reduced by the cost of goods in progress offset for the
taxable year, as determined under paragraphs (c)(3) through (5) of this
section. This net amount is required to be included in gross income for
the taxable year.
(A) AFS inventory inclusion amount for a taxable year. To determine
the AFS inventory inclusion amount for an item of inventory for a
taxable year:
(1) The taxpayer first takes the greater of the amount described in
paragraph (c)(2)(i)(A)(1)(i) of this section, or the amount described
in paragraph (c)(2)(i)(A)(1)(ii) of this section (or if the two amounts
are equal, the equal amount).
(i) The cumulative amount of revenue from the item of inventory
that satisfies the all events test under Sec. 1.451-1(a) through the
last day of the taxable year, less any advance payment inventory
inclusion amount, as defined in Sec. 1.451-8(a)(3), with respect to a
subsequent taxable year.
(ii) The cumulative amount of revenue from the item of inventory
that is treated as ``taken into account as AFS revenue'' under
paragraph (b)(2) of this section through the last day of the taxable
year.
(2) The taxpayer then reduces the amount determined under paragraph
(c)(2)(i)(A)(1) of this section by the amount computed under paragraph
(c)(2)(i)(A)(1) of this section for that item of inventory for the
immediately preceding taxable year.
(B) [Reserved]
(ii) Determining the gross income for the year of sale. To
determine the amount required to be included in gross income from the
sale of an item of inventory for the taxable year in which ownership of
the item of inventory is transferred to the customer:
(A) The taxpayer first takes the greater of the amount described in
paragraph (c)(2)(ii)(A)(1) of this section, or the amount described in
paragraph (c)(2)(ii)(A)(2) of this section (or if the two amounts are
equal, the equal amount).
(1) The cumulative amount of revenue from the item of inventory
that satisfies the all events test under Sec. 1.451-1(a) through the
last day of the taxable year, including the full amount of any advance
payment received for the item of inventory.
(2) The cumulative amount of revenue from the item of inventory
that is treated as ``taken into account as AFS revenue'' under
paragraph (b)(2) of this section through the last day of the taxable
year.
(B) The taxpayer then reduces such amount by any prior income
inclusion amounts with respect to such item of inventory. This net
amount is required to be included in gross income for the taxable year.
The taxpayer does not further reduce such amount by a cost of goods in
progress offset under paragraph (c)(3) of this section. However, the
taxpayer is entitled to recover the costs capitalized to the item of
inventory as cost of goods sold in accordance with sections 471 and
263A or any other applicable provision of the Internal Revenue Code.
See Sec. 1.61-3.
(3) Cost of goods in progress offset for a taxable year. The cost
of goods in progress offset for the taxable year is calculated as:
(i) The cost of goods allocable to the item of inventory through
the last day of the taxable year; reduced by
(ii) The cumulative cost of goods in progress offset attributable
to the item of inventory, if any.
[[Page 842]]
(4) Limitations to the cost of goods in progress offset. The cost
of goods in progress offset is determined separately for each item of
inventory. Further, the cost of goods in progress offset attributable
to one item of inventory cannot reduce the AFS inventory inclusion
amount attributable to a separate item of inventory. The cost of goods
in progress offset cannot reduce the AFS inventory inclusion amount for
the taxable year below zero.
(5) Inventory methods--(i) Inventory costs not affected by cost of
goods in progress offset. The cost of goods comprising the cost of
goods in progress offset does not reduce the costs that are capitalized
to the items of inventory produced or items of inventory acquired for
resale by the taxpayer. While the cost of goods in progress offset
reduces the AFS inventory inclusion amount, the cost of goods in
progress offset does not affect how and when costs are capitalized to
inventory under sections 471 and 263A or any other applicable provision
of the Internal Revenue Code or when those capitalized costs will be
recovered.
(ii) Consistency between inventory methods and AFS cost offset
method. The costs of goods comprising the cost of goods in progress
offset must be determined by applying the taxpayer's method of
accounting for inventory for Federal income tax purposes. A taxpayer
using the AFS cost offset method and, if applicable, the advance
payment cost offset method must calculate its cost of goods in progress
offset by reference to all costs that the taxpayer has permissibly
capitalized and allocated to items of inventory under its method of
accounting for inventory for Federal income tax purposes, but including
no more costs than what the taxpayer has permissibly capitalized and
allocated to items of inventory.
(iii) Allocation of ``additional section 263A costs'' for taxpayers
using simplified methods. If a taxpayer uses the simplified production
method as defined under Sec. 1.263A-2(b), the modified simplified
production method as defined under Sec. 1.263A-2(c), or the simplified
resale method as defined under Sec. 1.263A-3(d) to determine the
amount of its additional section 263A costs, as defined under Sec.
1.263A-1(d)(3), to be included in ending inventory, then solely to
compute the cost of goods in progress offset, the taxpayer must
determine the portion of additional section 263A costs allocable to an
item of inventory by multiplying its total additional section 263A
costs accounted for under the simplified method for all items of
inventory subject to the simplified method by the following ratio:
Section 471 costs allocable to the specific item of inventory
Total section 471 costs for all items of inventory subject to the
simplified method
(6) Acceleration of gross income. A taxpayer that uses the AFS cost
offset method or the advance payment cost offset method must include in
gross income for a taxable year prior to the taxable year in which an
item of inventory is transferred to the customer, all payments received
for the item of inventory that were not previously included in gross
income:
(i) If, in that taxable year, the taxpayer either dies or ceases to
exist in a transaction other than a transaction to which section 381(a)
applies; or
(ii) If, and to the extent that, in that taxable year, the
taxpayer's obligation to the customer with respect to the item of
inventory ends other than in:
(A) A transaction to which section 381(a) applies; or
(B) A section 351(a) transfer that is part of a section 351
transaction in which:
(1) Substantially all assets of the trade or business, including
the item of inventory, are transferred;
(2) The transferee adopts or uses, in the year of the transfer, the
same methods of accounting for the item of inventory under this section
and Sec. 1.451-8 as those used by the transferor; and
(3) The transferee and the transferor are members of the same
consolidated group, as defined in Sec. 1.1502-1(h).
(7) Additional procedural guidance. The IRS may publish procedural
guidance in the Internal Revenue Bulletin (see Sec. 601.601(d) of this
chapter) that provides alternative procedures for complying with the
rules under this paragraph (c), including alternative methods of
accounting for cost offsets.
(8) Examples. The following examples illustrate the AFS cost offset
method. Unless the facts specifically state otherwise, the taxpayer has
an AFS, is on a calendar year for both Federal income tax purposes and
AFS purposes, uses an accrual method of accounting for Federal income
tax purposes, and does not use a special method of accounting. Further,
the taxpayer properly applies its inventory accounting method, uses the
AFS cost offset method under paragraph (c) of this section, and, except
as otherwise provided, does not receive advance payments. Lastly, the
taxpayer does not produce unique items, as described in Sec. 1.460-
2(a)(1) and (b), or any item that normally requires more than 12
calendar months to complete, as determined under Sec. 1.460-2(a)(2)
and (c). Any production period that exceeds 12 calendar months is due
to unforeseen production delays.
(i) Example 1--(A) Facts. During 2021, A enters into a contract
with Customer to manufacture and deliver a good with a total contract
price of $100x. The costs to produce the good are required to be
capitalized under sections 471 and 263A as the good is inventory in the
hands of A. Ownership of the good is transferred from A to Customer
upon its delivery in 2022. A determines, under paragraph (c)(2)(i)(A)
of this section, that its AFS inventory inclusion amount for 2021 is
$20x. A incurs $12x of costs in 2021, and $48x of costs in 2022 ($60x
in total) that are permissibly capitalized and allocated to the
produced good under sections 471 and 263A. A has a fixed right to
receive the $100x contract price when it delivers the good in 2022. A
does not receive any payments from Customer prior to delivery. Further,
all $100x is treated as ``taken into account as AFS revenue'' as of the
last day of 2022.
(B) Analysis for 2021. For 2021, A's AFS income inclusion amount,
as determined under paragraph (c)(2)(i) of this section, is $8x ($20x
AFS inventory inclusion amount less $12x cost of goods in progress
offset, which is the cost of goods incurred through December 31, 2021).
(C) Analysis for 2022. During 2022, ownership of the good is
transferred to Customer. Accordingly, pursuant to paragraph (c)(2)(ii)
of this section, A determines the AFS income inclusion amount for 2022
by:
(1) First taking the greater of:
(i) The cumulative amount of revenue that satisfies the all events
test under Sec. 1.451-1(a) through the last day of 2022 ($100x); or
(ii) The cumulative amount of revenue that is treated as ``taken
into account as AFS revenue'' through the last day of 2022 ($100x) (or
if the two amounts are equal, the equal amount).
(2) Then subtracting from such amount ($100x) the prior income
inclusion amounts attributable to the transferred good ($8x). This net
amount of $92x is the AFS income inclusion amount for 2022. Although A
does not reduce such amount by a cost of goods in progress offset under
this paragraph (c), A is entitled to recover the $60x of costs
capitalized to the good as cost of goods sold in 2022 in accordance
with sections 471 and 263A. See Sec. 1.61-3. Accordingly, A's gross
income for 2022 is $32x.
[[Page 843]]
(ii) Example 2--(A) Facts. In December of 2021, A enters into a
contract with Customer to manufacture and deliver 10 items of inventory
at a price of $10x per item by the end of 2023. A determines, under
paragraph (c)(2)(i)(A) of this section, that the AFS inventory
inclusion amount attributable to each item of inventory under the
contract is $3x for 2021. A also incurs $10x of inventory costs during
2021. Such costs are permissibly capitalized and allocated under
sections 471 and 263A and are allocated equally to each item of
inventory under the contract ($1x per item). During 2022, the taxpayer
incurs $18x of costs to finish manufacturing 6 of the 10 items and
delivers such items to Customer in October of 2022. Such costs are
permissibly capitalized and allocated under sections 471 and 263A and
are allocated equally to each of the 6 items delivered in October of
2022 ($3x per item). Upon delivering the 6 items, ownership of the
delivered items transfers to Customer, A has a fixed right to receive
$60x of the total contract price, and all $60x is treated as ``taken
into account as AFS revenue.'' A does not incur any inventory costs
during 2022 that are allocable to the 4 remaining undelivered items,
nor does the taxpayer have an AFS inventory inclusion amount
attributable to such items for 2022. During 2023, A incurs $12x of
costs to finish manufacturing the 4 remaining items and delivers such
items to Customer. Such costs are permissibly capitalized and allocated
under sections 471 and 263A and are allocated equally to each of the 4
items delivered in 2023 ($3x per item). Upon delivering the 4 remaining
items, ownership of the items transfers to Customer, A has a fixed
right to receive the remaining $40x contract price, and all $40x is
treated as ``taken into account as AFS revenue.''
(B) Analysis for 2021 A's AFS income inclusion amount for 2021 is
$2x per item ($3x AFS inventory inclusion amount per item less $1x cost
of goods in progress offset per item, which is the cost of goods as of
December 31, 2021). Accordingly, A's total gross income inclusion for
2021 is $20x.
(C) Analysis for 2022. During 2022, ownership of 6 of the 10 items
is transferred to Customer. Accordingly, pursuant to paragraph
(c)(2)(ii) of this section, A determines the AFS income inclusion
amount for 2022 by:
(1) First taking the greater of:
(i) The cumulative amount of revenue that satisfies the all events
test under Sec. 1.451-1(a) through the last day of 2022 ($10x per
item); or
(ii) The cumulative amount of revenue that is treated as taken into
account as AFS revenue through the last day of 2022 ($10x per item) (or
if the two amounts are equal, the equal amount).
(2) Then subtracting from such amount ($10x per item) the prior
income inclusion amounts attributable to each transferred item ($2x per
item). This net amount of $8x per item is the AFS income inclusion
amount for each transferred item for 2022. Although A does not reduce
such amount by a cost of goods in progress offset under this paragraph
(c), A is entitled to recover the $4x of costs capitalized to each item
delivered as cost of goods sold in 2022 in accordance with sections 471
and 263A. Accordingly, on an aggregate basis, A's gross income for 2022
is $24x (aggregate AFS income inclusion amount for the 6 items
delivered in 2022 of $ 48x less aggregate cost of goods sold of $24x).
A does not include any amounts in gross income for 2022 with respect to
the 4 items of inventory that were not delivered to Customer until 2023
as A does not have an AFS inventory inclusion amount attributable to
such items for 2022.
(D) Analysis for 2023. During 2023, ownership of the 4 remaining
items are transferred to Customer. Based on the facts, A did not have
an AFS inventory inclusion amount attributable to the 4 remaining items
for 2022, nor did it incur any cost for such items in 2022 so the
analysis for the 4 remaining items for 2023 is similar to the analysis
for the 6 items transferred to the customer in 2022 on a per item
basis. Pursuant to paragraph (c)(2)(ii) of this section, A determines
the AFS income inclusion amount for 2023 by:
(1) First taking the greater of:
(i) The cumulative amount of revenue that satisfies the all events
test under Sec. 1.451-1(a) through the last day of 2023 ($10x per
item); or
(ii) The cumulative amount of revenue that is treated as taken into
account as AFS revenue through the last day of 2023 ($10x per item) (or
if the two amounts are equal, the equal amount).
(2) Then subtracting from such amount ($10x per item) the prior
income inclusion amounts attributable to each transferred item ($2x per
item). This net amount of $8x per item is the AFS income inclusion
amount for each transferred item for 2023. Although A does not reduce
such amount by a cost of goods in progress offset under this paragraph
(c), A is entitled to recover the $4x of costs capitalized to each item
delivered as cost of goods sold in 2023 in accordance with sections 471
and 263A. On an aggregate basis, A's gross income for 2023 is $16x
(aggregate AFS income inclusion amount for the 4 items delivered in
2023 of $32x less aggregate cost of goods sold of $16x).
(iii) Example 3--(A) Facts. In December of 2021, A enters into a
contract with Customer to manufacture and deliver a good with a total
contract price of $100x. The costs to produce the good are required to
be capitalized under sections 471 and 263A as the good is inventory in
the hands of the taxpayer. Ownership of the good is transferred from A
to Customer upon its delivery in January of 2023. A determines, under
paragraph (c)(2)(i)(A) of this section, that its AFS inventory
inclusion amount for 2021 and 2022 is $40x per year. A incurs $25x of
costs each year ($75x in total) that are permissibly capitalized and
allocated to the manufactured good under sections 471 and 263A. A has a
fixed right to receive the $100x contract price when it delivers the
good in January of 2023. A does not receive any payments from Customer
prior to delivery. Further, all $100x is treated as ``taken into
account as AFS revenue'' as of the last day of 2023.
(B) Analysis for 2021 and 2022. For 2021, A's AFS income inclusion
amount, as determined under paragraph (c)(2)(i) of this section, is
$15x ($40x AFS inventory inclusion amount for 2021 less the $25x cost
of goods in progress offset for 2021, which is equal to the cost of
goods as of December 31, 2021). For 2022, A's AFS income inclusion
amount is $15x ($40x AFS inventory inclusion amount for 2022 less the
$25x cost of goods in progress offset for 2022, which is the $50x cost
of goods as of December 31, 2022 less the 25x cumulative cost of goods
in progress offset amount taken into account in 2021).
(C) Analysis for 2023. During 2023, ownership of the good is
transferred to Customer. Accordingly, pursuant to paragraph (c)(2)(ii)
of this section, A determines the AFS income inclusion amount for 2023
by:
(1) First taking the greater of:
(i) The cumulative amount of revenue that satisfies the all events
test under Sec. 1.451-1(a) through the last day of 2023 ($100x); or
(ii) The cumulative amount of revenue that is treated as ``taken
into account as AFS revenue'' through the last day of 2023 ($100x) (or
if the two amounts are equal, the equal amount).
(2) Then subtracting from such amount ($100x) the prior income
inclusion amounts attributable to the transferred good of $30x ($15x
for 2021 and $15x for 2022). This net amount of $70x is the AFS income
inclusion
[[Page 844]]
amount for 2023. Although A does not reduce such amount by a cost of
goods in progress offset under this paragraph (c), A is entitled to
recover the $75x of costs capitalized to the good as cost of goods sold
in 2023 in accordance with sections 471 and 263A. See Sec. 1.61-3.
Accordingly, A's gross income for 2025 is -$5x.
(iv) Example 4--(A) Facts. In December 2021, A enters into a
contract with Customer to manufacture and deliver a good with a total
contract price of $100x. A reports $5x of AFS revenue for 2021, $90x of
cumulative AFS revenue through the end of 2022, and $100x of cumulative
AFS revenue through the end of 2023. A has an enforceable right to
recover all AFS revenue reported through the end of each contract year
if Customer were to terminate the contract on the last day of each
year. Under the terms of the contract, A is entitled to and receives a
payment of $40x in 2021 and a payment of $60x when Customer accepts
delivery of the good in 2023, which is also when ownership of the good
transfers to Customer. The costs to produce the good are required to be
capitalized under sections 471 and 263A as the good is inventory in the
hands of A. A incurs $10x of costs in 2021, $55x of costs in 2022, and
$5x of costs in 2023 ($70x in total). Such costs are permissibly
capitalized and allocated to the produced good under sections 471 and
263A. A uses the AFS cost offset method under paragraph (c) of this
section and accounts for advance payments, as defined in Sec. 1.451-
8(a)(1), under the deferral method and advance payment cost offset
method under Sec. 1.451-8(c) and (e), respectively.
(B) Analysis for 2021. The $40x payment A receives in 2021 meets
the definition of an advance payment under Sec. 1.451-8(a)(1) as the
full inclusion of $40x in gross income in the year of receipt is a
permissible method of accounting, a portion of the payment ($35x) is
``taken into account as AFS revenue'' in a subsequent year, and the
payment is for a good. Pursuant to Sec. 1.451-8(a)(3), A's advance
payment inventory inclusion amount for 2022 is $35x (the portion of the
payment deferred for AFS purposes). Pursuant to paragraph (c)(2)(i) of
this section, A must first determine the AFS inventory inclusion amount
for 2021 by applying the rules in paragraph (c)(2)(i)(A) of this
section. A then reduces such amount by the cost of goods in progress
offset for 2021, as determined under paragraphs (c)(3) through (5) of
this section.
(1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first
takes the greater of:
(i) The cumulative amount of revenue that satisfies the all events
test under Sec. 1.451-1(a) through the last day of 2021, less any
advance payment inventory inclusion amount attributable to a subsequent
year ($5x, determined as the $40x under the all events test, less the
$35x of advance payment inventory inclusion amount attributable to
2022); or
(ii) The cumulative amount of revenue that is treated as ``taken
into account as AFS revenue'' through the last day of 2021 ($5x) (or if
the two amounts are equal, the equal amount).
(2) Pursuant to paragraph (c)(2)(i)(A)(2) of this section, A then
subtracts from such amount ($5x) the amount determined under paragraph
(c)(2)(i)(A)(1) of this section for the item of inventory for the
immediately preceding year ($0). This net amount of $5x is the AFS
inventory inclusion amount for 2021.
(3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this
$5x AFS inventory inclusion amount by the cost of goods in progress
offset for 2021 of $5x, determined as the cost of goods as of December
31, 2021 of $10x, less the cumulative cost of goods in progress offset
taken into account in prior years of $0, less 5x for the AFS inventory
inclusion amount limitation under paragraph (c)(4) of this section.
Accordingly, A is required to include $0 in gross income for 2021.
(C) Analysis for 2022. Pursuant to paragraph (c)(2)(i) of this
section, A must first determine the AFS inventory inclusion amount for
2022 by applying the rules in paragraph (c)(2)(i)(A) of this section. A
then reduces such amount by the cost of goods in progress offset for
2022, as determined under paragraphs (c)(3) through (5) of this
section.
(1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first
takes the greater of:
(i) The cumulative amount of revenue that satisfies the all events
test under Sec. 1.451-1(a) through the last day of 2022 ($40x); or
(ii) The cumulative amount of revenue that is treated as ``taken
into account as AFS revenue'' through the last day of 2022 ($90x).
(2) Pursuant to (c)(2)(i)(A)(2) of this section, A then subtracts
from such amount ($90x) the amount determined under paragraph
(c)(2)(i)(A)(1) of this section for the item of inventory for 2021
($5x). This net amount of $85x is the AFS inventory inclusion amount
for 2022.
(3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this
$85x AFS inventory inclusion amount by the cost of goods in progress
offset for 2022 of $60x, determined as the cost of goods as of December
31, 2022 of $65x, less the cumulative cost of goods in progress offset
taken into account in prior years of $5x. Accordingly, A is required to
include $25x in gross income for 2022.
(D) Analysis for 2023. During 2023, ownership of the good is
transferred to Customer. Accordingly, pursuant to paragraph (c)(2)(ii)
of this section, A determines its gross income inclusion for 2023 by:
(1) First taking the greater of:
(i) The cumulative amount of revenue that satisfies the all events
test under Sec. 1.451-1(a) through the last day of 2023 ($100x); or
(ii) The cumulative amount of revenue that is treated as ``taken
into account as AFS revenue'' through the last day of 2023 ($100x) (or
if the two amounts are equal, the equal amount).
(2) Then subtracting from such amount ($100x) the prior income
inclusion amounts attributable to the transferred good of $25x ($0 for
2021 plus $25x for 2022). A is required to include this net amount of
$75x in gross income for 2023. Although A does not reduce such amount
by a cost of goods in progress offset under this paragraph (c), A is
entitled to recover the $70x of costs capitalized to the good as cost
of goods sold in 2023 in accordance with sections 471 and 263A. See
Sec. 1.61-3. Accordingly, A's gross income for 2023 is $5x.
(v) Example 5--(A) Facts. The same facts as in paragraph (c)(8)(iv)
of this section (Example 4) apply, except that in 2022, A's obligation
to Customer with respect to the good ends other than in a transaction
to which section 381(a) applies, or a section 351 transaction described
in paragraph (c)(6)(ii)(B) of this section. A does not receive any
additional payments in 2022.
(B) Analysis for 2021. The analysis for 2021 is the same as in
paragraph (c)(8)(iv) of this section (Example 4).
(C) Analysis for 2022. Because, in 2022, A's obligation to Customer
with respect to the good ends in a transaction other than a transaction
described in paragraph (c)(6)(ii)(A) or (B) of this section, A is
required to apply the acceleration rules in paragraph (c)(6) of this
section. Accordingly, because A received $40x of payments as of the
date of the transaction, but did not include any portion of such
payments in gross income in prior years, A is required to include the
remaining $40x of the payments received in gross income in 2022
pursuant to paragraph (c)(6) of this section. A is not permitted to
further reduce the $40x income inclusion by a cost of goods in progress
offset under this paragraph (c).
[[Page 845]]
(vi) Example 6--(A) Facts. In 2021, A enters into a contract with
Customer to produce and deliver a good. The contract provides that A
will receive payments equal to AFS costs plus a 100% mark-up, however,
A can only bill the customer on December 31, 2022 and, if the good is
not delivered by December 31, 2022, A can also bill Customer upon
delivery of the good, for the AFS costs (plus markup) incurred to date,
less any amounts previously billed. A recognizes AFS revenue based on a
percentage of completion (cost to cost) method. A recognizes AFS
revenue of $100 through the last day of 2021, $150 through the last day
of 2022, and $300 through the last day of 2023, and has an enforceable
right to all AFS revenue reported as of the end of each year if the
customer were to terminate the contract on the last day of the year. A
bills the customer $150 on December 31 of 2022 and $150 in 2023 when A
delivers the good and ownership transfers to Customer. The costs to
produce the good are required to be capitalized under sections 471 and
263A as the good is inventory in the hands of the taxpayer. A incurs
the following costs each year that are permissibly capitalized and
allocated to the produced good under sections 471 and 263A: $125 in
2021; $0 in 2022; and $25 in year 2023.
(B) Analysis for taxable year 2021. Pursuant to paragraph (c)(2)(i)
of this section, A must first determine the AFS inventory inclusion
amount for 2021 by applying the rules in paragraph (c)(2)(i)(A) of this
section. A then reduces such amount by the cost of goods in progress
offset for 2021, as determined under paragraphs (c)(3) through (5) of
this section.
(1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first
takes the greater of:
(i) The cumulative amount of revenue that satisfies the all events
test under Sec. 1.451-1(a) through the last day of 2021 ($0); or
(ii) The cumulative amount of revenue that is treated as ``taken
into account as AFS revenue'' through the last day of 2021 ($100).
(2) Pursuant to paragraph (c)(2)(i)(A)(2) of this section, A then
subtracts from such amount ($100) the amount determined under paragraph
(c)(2)(i)(A)(1) of this section for the item of inventory for the
immediately preceding year ($0). This net amount of $100 is the AFS
inventory inclusion amount for 2021.
(3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this
$100 AFS inventory inclusion amount by the cost of goods in progress
offset for 2021 of $100. Although A's cost of goods in progress as of
the end of 2021 is $125, the cost of goods in progress offset is
limited to $100, the amount of A's AFS inventory inclusion amount for
2021. Accordingly, A is required to include $0 in gross income in 2021.
(C) Analysis for taxable year 2022. Pursuant to paragraph (c)(2)(i)
of this section, A must first determine the AFS inventory inclusion
amount for 2022 by applying the rules in paragraph (c)(2)(i)(A) of this
section. A then reduces such amount by the cost of goods in progress
offset for 2022, as determined under paragraphs (c)(3) through (5) of
this section.
(1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first
takes the greater of:
(i) The cumulative amount of revenue that satisfies the all events
test under Sec. 1.451-1(a) through the last day of 2022 ($150 due
under the terms of the contract); or
(ii) The cumulative amount of revenue that is treated as ``taken
into account as AFS revenue'' through the last day of 2022 ($150) (or
if the two amounts are equal, the equal amount).
(2) Pursuant to paragraph (c)(2)(i)(A)(2) of this section, A then
subtracts from such amount ($150) the amount determined under paragraph
(c)(2)(i)(A)(1) of this section for the item of inventory for the
immediately preceding year ($100). This net amount of $50 is the AFS
inventory inclusion amount for 2022.
(3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this
$50 AFS inventory inclusion amount by the cost of goods in progress
offset for 2022 of $25, determined as $125 cost of goods as of December
31, 2022 minus $100 cumulative cost of goods in progress offset amount
taken into account in 2021. Accordingly, A is required to include $25
in gross income for 2022.
(D) Analysis for taxable year 2023. During 2023, ownership of the
good is transferred to the customer. Accordingly, pursuant to paragraph
(c)(2)(ii) of this section, A determines its gross income inclusion for
2023 by:
(1) First taking the greater of:
(i) The cumulative amount of revenue that satisfies the all events
test under Sec. 1.451-1(a) through the last day of 2023 ($300x); or
(ii) The cumulative amount of revenue that is treated as ``taken
into account as AFS revenue'' through the last day of 2025 ($300x) (or
if the two amounts are equal, the equal amount).
(2) Then subtracting from such amount ($300x) the prior income
inclusion amounts attributable to the transferred good of $25 ($0 for
2021 plus $25 for 2022). This net amount of $275 is the AFS income
inclusion amount for 2023. Although A does not reduce such amount by a
cost of goods in progress offset under this paragraph (c), A is
entitled to recover the $150 of costs capitalized to the good as cost
of goods sold in 2023 in accordance with sections 471 and 263A. See
Sec. 1.61-3. Accordingly, A's gross income for 2023 is $125 ($275 AFS
income inclusion amount less $150 cost of goods sold).
(d) Contracts with multiple performance obligations--(1) In
general. Each performance obligation generally yields a corresponding
item of gross income that must be accounted for separately under the
AFS income inclusion rule in paragraph (b)(1) of this section. Except
as provided in paragraph (d)(5) of this section, if a contract contains
more than one performance obligation, and thus yields more than one
corresponding item of gross income, the transaction price amount shall
be allocated to each corresponding item of gross income in accordance
with the transaction price amount allocated to each performance
obligation for AFS purposes, subject to the adjustments to the
transaction price amount and special allocation rules in paragraph
(d)(3) of this section.
(2) Single performance obligation with more than one item of gross
income. If a single performance obligation yields more than one
corresponding item of gross income, the transaction price amount
allocated to the single performance obligation for AFS purposes must be
further allocated among the corresponding items of gross income using
any reasonable method.
(3) Adjustments to transaction price amount and special allocation
rules--(i) Increases to transaction price amount. If the transaction
price amount includes a reduction for amounts described in paragraph
(b)(2)(i)(A)(1) or (2) of this section, or has been reduced because a
significant financing component is deemed to exist under the standards
the taxpayer uses to prepare its AFS, the taxpayer must determine the
specific performance obligation to which such reduction relates and
increase the transaction price amount allocable to the corresponding
item of gross income by the amount of such reduction (specific
identification approach). If it is impracticable from the taxpayer's
records to use the specific identification approach, the taxpayer may
use any reasonable method to allocate the reduction amount to the items
of gross income in the contract. A pro-rata allocation of the reduction
amount across all items of gross income under the contract based on the
relative
[[Page 846]]
transaction price amounts allocated to such items under paragraph
(d)(1) of this section is a reasonable method.
(ii) Decrease to transaction price amount. If the transaction price
amount has been increased because a significant financing component is
deemed to exist under the standards the taxpayer uses to prepare its
AFS, the taxpayer must determine the specific performance obligation to
which such amount relates and decrease the transaction price amount
allocable to the corresponding item of gross income by such amount
(specific identification approach). If it is impracticable from the
taxpayer's records to use the specific identification approach, the
taxpayer may use any reasonable method to allocate such amount to the
items of gross income in the contract. A pro-rata allocation of such
amount across all items of gross income under the contract based on the
relative transaction price amounts allocated to such items under
paragraph (d)(1) of this section is a reasonable method.
(4) Examples. The following examples illustrate the rules of
paragraph (d)(1) through (3) of this section. Unless the facts
specifically state otherwise, the taxpayer has an AFS, is on a calendar
year for Federal income tax purposes and AFS purposes, and uses an
accrual method of accounting for Federal income tax purposes.
(i) Example 1--(A) Facts. On November 1, 2021, A, a software
developer, enters into a contract with a customer to transfer a
software license, perform software installation services, and provide
technical support for a two-year period for $100x. The installation
service does not significantly modify the software and the software
remains functional without the technical support. A receives an
additional $10x bonus if the installation service is performed before
February 1, 2022, which A expects to receive. Further, the customer is
entitled to a refund of $2x if technical support does not meet
performance standards set forth in the contract, which A expects it
will pay to the customer. For its AFS, A identifies three performance
obligations in the contract:
(1)(i) The software license;
(ii) The installation service; and
(iii) Technical support.
(2) Also, for its AFS, A determines that the transaction price
amount is $108x, determined as $100x contract price plus $10x bonus for
installation services minus $2x customer refund. Finally, for its AFS,
A allocates the $108x transaction price amount to the three performance
obligations as follows: $60x to the software license; $40x to the
installation service ($30x + $10x bonus); and $8x to technical support
($10x-$2x refund).
(B) Analysis. Pursuant to paragraph (d)(1) of this section, A's
contract with the customer has three performance obligations, and each
performance obligation yields a corresponding item of gross income that
is accounted for separately. Pursuant to paragraph (d)(1) of this
section, A is required to allocate the $108x transaction price amount
to each corresponding item of gross income in accordance with the
transaction price amount allocated to each respective performance
obligation for AFS purposes. Accordingly, A initially allocates $60x to
the software license item, $40x to the installation service item, and
$8 to the technical support item. However, because the transaction
price amount was reduced by the anticipated refund of $2x, which
relates specifically to the technical support item, A must increase the
transaction price allocable to that item of gross income pursuant to
the specific identification approach in paragraph (d)(3) of this
section. Accordingly, the amount allocated to the item of gross income
related to technical support is $10x.
(ii) Example 2--(A) Facts. In 2021, B, a manufacturer and servicer
of airplane parts, enters into a contract with a customer to sell
airplane parts in 2021 and to service those parts, as necessary, in
2021, 2022, and 2023 for $100x. B regularly sells the airline parts and
the services separately. For its AFS, B identifies two performance
obligations in the contract:
(1)(i) The sale of airplane parts; and
(ii) The services for those parts.
(2) The customer receives a refund of $5x if it does not require a
specified level of service for the parts, which B expects it will pay
to the customer. Also, for its AFS, B determines that the transaction
price amount is $95x, determined as the $100x contract price minus the
$5x refund that it expects to pay the customer. Finally, for its AFS, B
allocates the $95x transaction price amount to the two performance
obligations as follows: $40x to the sale of parts and $55x to the
provision of services ($60x-$5x refund).
(B) Analysis. Pursuant to paragraph (d)(1) of this section, B's
contract with the customer has two performance obligations, and each
performance obligation yields a corresponding item of gross income that
is accounted for separately. Pursuant to paragraph (d)(1) of this
section, B is required to allocate the $95x transaction price amount to
each corresponding item of gross income in accordance with the
transaction price amount allocated to each respective performance
obligation for AFS purposes. Accordingly, B initially allocates $40x to
the sale of parts item and $55x to the provision of services item.
However, because the transaction price amount was reduced by the
anticipated refund of $5x, which relates specifically to provision of
services item, B must increase the transaction price allocable to that
item of gross income pursuant to the specific identification approach
in paragraph (d)(3) of this section. Accordingly, the amount allocated
to the item of gross income related to servicing the parts is $60x.
(iii) Example 3: Reward points--(A) Facts. On December 31, 2021, U,
in the business of selling consumer electronics, sells a new TV for
$1,000 and gives the customer 50 reward points. Each reward point is
redeemable for a $1 discount on any future purchase of U's products.
For its AFS, U identifies two performance obligations from the
transaction:
(1)(i) The sale of the TV; and
(ii) The provision of rewards points.
(2) Also, for its AFS, U allocates $950 of transaction price amount
to the sale of the TV and the remaining $50 of the transaction price
amount to the reward points.
(B) Analysis. Pursuant to paragraph (d)(1) of this section, U's
contract with the customer has two performance obligations, and each
performance obligation yields a corresponding item of gross income that
is accounted for separately. Pursuant to paragraph (d)(1) of this
section, U is required to allocate the $1,000 transaction price amount
to each corresponding item of gross income in accordance with the
transaction price amount allocated to each respective performance
obligation for AFS purposes. Accordingly, U allocates the transaction
price amount as follows: $950 to the TV sale item and $50 to the reward
points item. If U reports any portion of the $50 payment allocated to
the reward points as AFS revenue for 2022, or later, the payment is an
advance payment, as defined in Sec. 1.451-8(a)(1), and may be
accounted for under the deferral method if U satisfies the criteria in
Sec. 1.451-8(c).
(iv) Example 4: Airline reward miles--(A) Facts. On January 1,
2021, W, a passenger airline company, sells a customer a $700 airline
ticket to fly roundtrip in 2021. As part of the purchase, the customer
receives 7,000 points (air miles) from W to be redeemed for future air
travel. For its AFS, W identifies two performance obligations in the
contract:
(1)(i) The sale of the airline ticket; and
[[Page 847]]
(ii) The provision of air miles.
(2) W also anticipates that it will issue a rebate to the customer
for $10. Also, for its AFS, W determines that the transaction price
amount is $690, determined as the $700 ticket price minus the
anticipated $10 rebate. Finally, for its AFS, W allocates the $690
transaction price amount to the separate performance obligations as
follows: $660 to the ticket ($670-$10 rebate = $660) and $30 to the air
miles.
(B) Analysis. Pursuant to paragraph (d)(1) of this section, W's
contract with the customer has two performance obligations, and each
performance obligation yields a corresponding item of gross income that
is accounted for separately. Pursuant to paragraph (d)(1) of this
section, W must allocate the $690 transaction price amount to each
corresponding item of gross income in accordance with the transaction
price amount allocated to each respective performance obligation for
AFS purposes. Accordingly, W initially allocates $660 to the ticket
sale item and $30 to the air miles item. However, because the
transaction price amount was reduced by the anticipated rebate of $10x,
which relates to the ticket sale item, W must increase the transaction
price allocable to that item of gross income pursuant to paragraph
(d)(3) of this section. Accordingly, the amount allocated to the item
of gross income related to the ticket sale is $670. If W reports any
portion of the $30 payment allocated to the air miles item as AFS
revenue for 2022, or later, the payment is an advance payment, as
defined in Sec. 1.451-8(a)(1), and may be accounted for under the
deferral method if W satisfies the criteria in Sec. 1.451-8(c).
(v) Example 5: Contract with significant financing component
amounts--(A) Facts. On January 1, 2021, C, a manufacturer and servicer
of airline parts, enters into a contract with a customer to sell
airline parts in December 2022, and to service those parts, as
necessary, through 2024. The contract contains two alternative payment
options: payment of $5,000 in December 2022 when the customer obtains
control of the parts or payment of $4,000 when the contract is signed.
The customer pays $4,000 when the contract is signed, which reflects an
implicit interest rate of 11.8% and is C's incremental borrowing rate.
C regularly sells the airline parts and the services separately. For
its AFS, C identifies two performance obligations in the contract:
(1)(i) The sale of airplane parts; and
(ii) The services for those parts.
(2) Also, for its AFS, although the contract only requires the
customer to pay $4,000, the transaction price is increased by $1,000 to
$5,000 because the customer is deemed to provide financing to C under
the standards C uses to prepare its AFS. The $1,000 increase is
attributable to a significant financing component. Finally, for its
AFS, C allocates the $5,000 transaction price amount to the separate
performance obligations as follows: $3,750 to the sale of parts ($3,000
upfront payment plus $750 financing component) and $1,250 ($1,000
upfront payment plus $250 financing component) to the provision of
services.
(B) Analysis. Pursuant to paragraph (d)(1) of this section, C's
contract with the customer has two performance obligations, and each
performance obligation yields a corresponding item of gross income that
is accounted for separately. Pursuant to paragraph (d)(1) of this
section, C must allocate the $5,000 transaction price amount to each
corresponding item of gross income in accordance with the transaction
price amount allocated to each respective performance obligation for
AFS purposes. Accordingly, C initially allocates $3,750 to the sale of
the parts item and $1,250 to the provision of services item. However,
because the transaction price was increased by a significant financing
component of $1,000, $750 of which was allocated to sale of the parts
item and $250 of which was allocated to the provision of services item,
pursuant to paragraph (d)(3) of this section, C must decrease the
transaction price amount allocable to the sale of parts item from
$3,750 to $3,000 and must decrease the transaction price allocable to
the provision of services from $1,250 to $1,000.
(5) Contracts accounted for in part under this section and in part
under a special method of accounting--(i) In general. If a taxpayer has
a contract with a customer that includes one or more items of gross
income that are subject to a special method of accounting and one or
more items of gross income that are subject to this section (special
method/451 contract), the transaction price allocation rule in
paragraph (d)(1) of this section does not apply to determine the amount
of each item of gross income that is subject to a special method of
accounting. For purposes of this paragraph (d)(5)(i), a special method
of accounting has the meaning set forth in paragraph (a)(13) of this
section, except as otherwise provided in guidance published in the
Internal Revenue Bulletin (see Sec. 601.601(d) of this chapter). For
special method/451 contracts, paragraphs (d)(5)(ii) and (iii) of this
section apply to determine the transaction price amount and the portion
of such amount that is allocated to each item of gross income that is
subject to this section.
(ii) Transaction price adjustments. If the transaction price amount
for the special method/451 contract includes a reduction for amounts
described in paragraph (b)(2)(i)(A)(1) or (2) of this section, or has
been reduced because a significant financing component is deemed to
exist under the standards the taxpayer uses to prepare its AFS, the
taxpayer must increase the transaction price amount by the amount of
such reduction. If the transaction price amount for the special method/
451 contract has been increased because a significant financing
component is deemed to exist under the standards the taxpayer uses to
prepare its AFS, the taxpayer must decrease the transaction price
amount by the amount of such increase.
(iii) Transaction price allocation. After the taxpayer determines
the adjusted transaction price amount for the special method/451
contract under paragraph (d)(5)(ii) of this section, the taxpayer first
allocates such amount to the item(s) of gross income subject to a
special method of accounting and then allocates the remainder (residual
amount) to the item(s) of gross income that are subject to this
section. If the contract contains more than one item of gross income
that is subject to this section, the taxpayer allocates the residual
amount to such items in proportion to the amounts allocated to the
corresponding performance obligations for AFS purposes or as otherwise
provided in guidance published in the Internal Revenue Bulletin (see
Sec. 601.601(d) of this chapter).
(iv) Example--(1) Facts. B is a calendar-year accrual method
taxpayer with an AFS. In 2020, B enters into a $100x contract to
design, build, operate and maintain a toll road. The contract meets the
definition of a long-term contract under Sec. 1.460-1(b)(1). B
determines that the obligations to design and build the toll road are
long-term contract activities under Sec. 1.460-1(d)(1) and accounts
for the gross income from these activities under section 460 and the
regulations in this part under section 460 of the Code. In addition, B
determines that the obligations to operate and maintain the toll road
are non-long-term contract activities under Sec. 1.460-1(d)(2) and
that the gross income attributable to these activities is required to
be accounted for under this section. B determines that of the $100x
transaction price amount, $60x is properly allocable to the items of
gross income that are subject to section 460
[[Page 848]]
and the regulations in this part under section 460 of the Code.
However, for its AFS, B allocates $55x of the transaction price amount
to performance obligations that are long-term contract activities, $30x
to the toll road operation performance obligation and $15x to the toll
road maintenance performance obligation.
(2) Analysis. A method of accounting under section 460 is a special
method of accounting that is within the scope of paragraph (d)(5) of
this section. Pursuant to paragraph (d)(5) of this section, B first
allocates $60x of the transaction price amount to the items of gross
income that are subject to section 460 and the regulations in this part
under section 460 of the Code and then allocates the residual amount of
$40x to the two items of gross income that are required to be accounted
for under this section in proportion to the amounts allocated to the
corresponding performance obligations for AFS purposes. Accordingly, B
allocates $26.7 x ($30x/$45x x $40x residual amount) to the toll road
operations item of gross income and $13.3x ($15x/$45x x $40x residual
amount) to the toll road maintenance item of gross income.
(e) Cumulative rule for multi-year contracts--(1) In general. In
the case of an item of gross income from a multi-year contract, a
taxpayer determines the AFS income inclusion amount for a taxable year
by applying the steps in paragraph (e)(1)(i) or (ii) of this section.
For this paragraph (e), the term multi-year contract means a contract
that spans more than one taxable year.
(i) Inventory items. If the item of gross income is from the sale
of an item of inventory and the taxpayer uses the cost offset method
under paragraph (c) of this section, see paragraph (c) of this section.
(ii) Other items of gross income. For all other items of gross
income, the taxpayer first compares the cumulative amount of the item
of gross income that satisfies the all events test under Sec. 1.451-
1(a) through the last day of the taxable year, including the full
amount of any advance payment received for such item in a prior taxable
year, with the cumulative amount of the item of gross income that is
treated as ``taken into account as AFS revenue'' under paragraph (b)(2)
of this section through the last day of the taxable year and identifies
the larger of the two amounts (or, if the two amounts are equal, the
equal amount). The taxpayer then reduces such amount by all prior year
inclusion amounts attributable to the item of gross income, if any, to
determine the AFS income inclusion amount for the current taxable year.
If, however, the taxpayer receives an advance payment, as defined in
Sec. 1.451-8(a)(1), that is allocable to an item of gross income from
a multi-year contract, the taxpayer applies the applicable rules in
Sec. 1.451-8, rather than the rules in this paragraph (e)(1)(ii), to
determine the amount of the item of gross income that is required to be
included in gross income in the taxable year in which such advance
payment is received, or, if applicable, in a short taxable year
described in Sec. 1.451-8(c)(6).
(2) Examples. The following examples illustrate the rules of
paragraph (e)(1) of this section. Unless the facts specifically state
otherwise, the taxpayer has an AFS, is on a calendar year for both
Federal income tax purposes and AFS purposes and uses an accrual method
of accounting for Federal income tax purposes. Further, the taxpayer
does not use a special method of accounting.
(i) Example 1: Provision of services included in AFS revenue with
full inclusion method for advance payments--(A) Facts. In 2021, D, an
engineering services provider, enters into a nonseverable contract with
a customer to provide engineering services through 2024 for a total of
$100x. Under the contract, D receives payments of $25x in each calendar
year of the contract. For its AFS, D reports $50x, $0, $20x, and $30x
of AFS revenue from the contract for 2021, 2022, 2023, and 2024,
respectively. D has an enforceable right to recover all amounts
reported as AFS revenue through the end of a given contract year if the
customer were to terminate the contract on the last day of such year.
The $25x payment received in 2023 is an advance payment, as defined in
Sec. 1.451-8(a)(1), because $5x of the $25x payment is reported as AFS
revenue for 2024. D uses the full inclusion method for advance
payments.
(B) Taxable year 2021. Under the all events test in Sec. 1.451-
1(a), D is required to include $25x in gross income in 2021 as $25x is
due under the terms of the contract and received by D during 2021. D
does not have a fixed right to receive any portion of the remaining $75
as such amount is not due under the terms of the contract until future
years and is also contingent on D's completion of the nonseverable
services. Under the AFS income inclusion rule, because D has an
enforceable right to recover all $50x reported as AFS revenue for 2021
if the customer were to terminate the contract on the last day of such
year, all $50x is treated as ``taken into account as AFS revenue'' in
2021. Accordingly, D is required to include $50x in gross income in
2021.
(C) Taxable year 2022. Under the all events test in Sec. 1.451-
1(a), D is required to include $50x in gross income through the end of
2022 as $50x is due under the terms of the contract and received by D
as of the end of 2022. D does not have a fixed right to receive any
portion of the remaining $50 as such amount is not due under the terms
of the contract until future years and is also contingent on D's
completion of the nonseverable services. Under the AFS income inclusion
rule, because D has an enforceable right to recover all $50x reported
as AFS revenue through the end of 2022 if the customer were to
terminate the contract on the last day of such year, all $50x is
treated as ``taken into account as AFS revenue'' as of the last day of
2022. Under the cumulative rule in paragraph (e)(1)(ii) of this
section, D compares the cumulative all events test amount of $50x with
the cumulative AFS revenue amount of $50x and selects the larger of the
two amounts (or if the two amounts are equal, the equal amount). From
this equal amount of $50x, D subtracts the prior income inclusion
amount of $50x. Accordingly, under the cumulative rule D is not
required to include any amount in gross income in 2022.
(D) Taxable year 2023. The payment received during 2023 meets the
definition of an advance payment under Sec. 1.451-8(a)(1).
Accordingly, pursuant to paragraph (e)(1)(ii) of this section, D must
determine the amount that is required to be included in gross income in
2023 under the rules in Sec. 1.451-8. Because D uses the full
inclusion method under Sec. 1.451-8(b), D is required to include the
$25x that was due and received during 2023 in gross income in 2023.
(E) Taxable year 2024. Under the all events test in Sec. 1.451-
1(a), D is required to include $100x in gross income through the end of
2024 as $100x is due under the terms of the contract and received by D
as of the end of 2024. Under the AFS income inclusion rule, because D
has an enforceable right to recover all $100x reported as AFS revenue
through the end of 2024 if the customer were to terminate the contract
on the last day of such year, all $100x is treated as ``taken into
account as AFS revenue'' through the last day of 2024. Under the
cumulative rule in paragraph (e)(1)(ii) of this section, D compares the
cumulative all events test amount of $100x with the cumulative AFS
revenue amount of $100x and selects the larger of the two amounts (or,
if the two amounts are equal, the equal amount). From this equal amount
of $100x, D subtracts the prior income inclusion amount of $75x ($50x
from 2021 plus
[[Page 849]]
$0x from 2022 plus $25x from 2023). Accordingly, under the cumulative
rule D is required to include $25 in gross income in 2024. The example
in this paragraph (e)(2)(i)(E) is summarized in the following table:
Table 2 to Paragaph (e)(2)(i)(E)
----------------------------------------------------------------------------------------------------------------
2021 2022 2023 2024 Total
----------------------------------------------------------------------------------------------------------------
All Events/Full Inclusion Income $25x $25x $25x $25x $100x
AFS Revenue..................... 50x 0 20x 30x 100x
Cumulative rule income.......... 50x 0 25x 25x 100x
----------------------------------------------------------------------------------------------------------------
(ii) Example 2: Provision of services included in AFS revenue with
deferral method for advance payments--(A) Facts. The facts are the same
as in paragraph (e)(2)(i) of this section (Example 1), except D elects
to use the deferral method under Sec. 1.451-8(c) to account for
advance payments.
(B) Taxable years 2021 and 2022. The analysis for tax years 2021
and 2022 is the same as in paragraph (e)(2)(i) of this section (Example
1).
(C) Taxable year 2023. The payment received during 2023 meets the
definition of an advance payment under Sec. 1.451-8(a)(1).
Accordingly, pursuant to paragraph (e)(1)(ii) of this section, D must
determine the amount that is required to be included in gross income in
2023 under the rules in Sec. 1.451-8. Because D uses the deferral
method under Sec. 1.451-8(b), D is required to include $20x of the
$25x payment in gross income in 2023 as $20x of such payment was
treated as ``taken into account as AFS revenue'' as of the end of 2023.
(D) Taxable year 2024. Under the all events test in Sec. 1.451-
1(a), D is required to include $100x in gross income through the end of
2024. Under the AFS income inclusion rule, because D has an enforceable
right to recover all $100x reported as AFS revenue through the end of
2024 if the customer were to terminate the contract on the last day of
such year, all $100x is treated as ``taken into account as AFS
revenue'' through the last day of 2024. Under the cumulative rule in
paragraph (e)(1)(ii) of this section, D compares the cumulative all
events test amount of $100x, which includes the full amount of the $25
advance payment received in 2023, with the cumulative AFS revenue
amount of $100x and selects the larger of the two amounts (or, if the
two amounts are equal, the equal amount). From this equal amount of
$100x, D subtracts the prior income inclusion amount of $70x ($50x from
2021 plus $0x from 2022 plus $20x from 2023). Accordingly, under the
cumulative rule D is required to include $30x in gross income in 2024.
The example in this paragraph (e)(2)(ii)(D) is summarized in the
following table:
Table 3 to Paragraph (e)(2)(ii)(D)
----------------------------------------------------------------------------------------------------------------
2021 2022 2023 2024 Total
----------------------------------------------------------------------------------------------------------------
All Events Test/Deferral Method $25x $25x \1\ $20x $30x $100x
Income.........................
AFS Revenue amount.............. 50x 0 20x 30x 100x
Cumulative rule income.......... 50x 0 20x 30x 100x
----------------------------------------------------------------------------------------------------------------
\1\ $5x of the advance payment in 2023 is deferred and taken into income in 2024.
(f) No change in the treatment of a transaction. Except as provided
in paragraph (j) of this section and Sec. 1.1275-2(l), the AFS income
inclusion rule does not change the treatment of a transaction or the
character of an item for Federal income tax purposes. The following are
examples of transactions where the treatment or character for AFS
purposes does not change the treatment of the transaction or character
of the item for Federal income tax purposes:
(1) A transaction treated as a lease, license, or similar
transaction for Federal income tax purposes that is treated as a sale
or financing for AFS purposes, and vice versa;
(2) A transaction or instrument that is not required to be marked-
to-market for Federal income tax purposes but that is marked-to-market
for AFS purposes;
(3) Asset sale and liquidation treatment under section 336(e) or
338(h)(10);
(4) A distribution of a corporation or the allocable share of
partnership items or an income inclusion under section 951, 951A, or
1293(a) for Federal income tax purposes that is accounted for under the
equity method for AFS purposes;
(5) A distribution of previously taxed earnings and profits of a
foreign corporation; and
(6) A deposit, return of capital, or conduit payment that is not
gross income for Federal income tax purposes that is treated as AFS
revenue.
(g) No change to exclusion provisions and the treatment of non-
recognition transactions--(1) In general. The AFS income inclusion rule
accelerates the time at which the all events test under Sec. 1.451-
1(a) is treated as satisfied, and therefore does not change the
applicability of any exclusion provision, or the treatment of non-
recognition transactions, in the Code, the regulations in this part, or
other guidance published in the Internal Revenue Bulletin (see Sec.
601.601(d) of this chapter). The following are examples of exclusion
provisions and non-recognition transactions that are not affected by
the AFS income inclusion rule:
(i) Any non-recognition transaction, within the meaning of section
7701(a)(45), including, for example, a liquidation described in
sections 332 and 337, an exchange described in section 351, a
distribution described in section 355, a reorganization described in
section 368, a contribution described in section 721, or transactions
described in sections 1031 through 1045; and
(ii) Items specifically excluded from income under sections 101
through 140.
(2) Example: Non-recognition provisions not changed for Federal
income tax purposes--(i) Facts. Taxpayer (Distributing) is a calendar-
year accrual method C corporation with an AFS. On December 31, 2021,
Distributing:
(A)(1) Contributes assets to a wholly owned subsidiary (Controlled)
in exchange for Controlled stock and $100x; and
[[Page 850]]
(2) Distributes all the Controlled stock pro rata to its
shareholders.
(B) The transaction qualifies as a reorganization under section
368(a)(1)(D) and a distribution to which section 355 applies (D
reorganization). Distributing's realized gain on the transferred assets
for book and tax purposes is $150x. On January 15, 2022, in pursuance
of the plan of reorganization, Distributing distributes the $100x to
its shareholders. Consequently, no gain to Distributing is recognized
under section 361(b)(1)(A). On Distributing's 2021 AFS, Distributing
recognizes revenue of $150x related to the D reorganization.
(ii) Analysis. For Federal income tax purposes, under section 361,
Distributing does not recognize gain on Distributing's:
(A)(1) Contribution of assets to Controlled;
(2) Receipt of Controlled stock and cash; and
(3) Distribution of Controlled stock and cash to Distributing's
shareholders.
(B) Pursuant to paragraph (g) of this section, the AFS income
inclusion rule does not change the result of this paragraph (g)(2).
(h) Additional AFS issues--(1) AFS covering groups of entities--(i)
In general. If a taxpayer's financial results are reported on the AFS
for a group of entities (consolidated AFS), the taxpayer's AFS is the
consolidated AFS. However, if the taxpayer's financial results are also
reported on a separate AFS that is of equal or higher priority to the
consolidated AFS under paragraph (a)(5) of this section, then the
taxpayer's AFS is the separate AFS.
(ii) Example. Taxpayer B, a reseller of computers and electronics,
is a calendar-year accrual method taxpayer. In 2021, B's financial
results are included in P's consolidated financial statement, which is
certified as being prepared in accordance with GAAP, and is a Form 10-K
filed with the SEC. B also has a separate audited financial statement
prepared in accordance with GAAP that is used for credit purposes. B
must use its parent corporation's consolidated Form 10-K as its AFS.
(2) Separately listed items. If a consolidated AFS is treated as
the taxpayer's AFS, the taxpayer must include the amount of any items
listed separately in the consolidated AFS, including any notes or other
supplementary data that is considered part of the consolidated AFS, in
determining the amount of AFS revenue allocated to the taxpayer.
(3) Non-separately listed items. If a consolidated AFS does not
separately list items for the taxpayer, the portion of the AFS revenue
allocable to the taxpayer is determined by relying on the taxpayer's
separate source documents that were used to create the consolidated AFS
and includes amounts subsequently eliminated in the consolidated AFS.
Whether a taxpayer that changes the source documents it uses for this
purpose from one taxable year to another taxable year has changed its
method of accounting is determined under the rules of section 446.
(4) Computation of AFS revenue for the taxable year when the AFS
covers mismatched reportable periods--(i) In general. If a taxpayer's
AFS is prepared on the basis of a financial accounting year that
differs from the taxpayer's taxable year, the taxpayer must use one of
the following permissible methods of accounting described in paragraph
(h)(4)(i)(A) through (C) of this section to determine the AFS income
inclusion amount for the taxable year:
(A) The taxpayer computes AFS revenue as if its financial reporting
period is the same as its taxable year by conducting an interim closing
of its books using the accounting principles it uses to prepare its
AFS.
(B) The taxpayer computes AFS revenue by including a pro rata
portion of AFS revenue for each financial accounting year that includes
any part of the taxpayer's taxable year. If the taxpayer's AFS for part
of the taxable year is not available by the due date of the return
(with extension), the taxpayer must make a reasonable estimate of AFS
revenue for the pro rata portion of the taxable year for which an AFS
is not yet available. See Sec. 1.451-1(a) for adjustments after actual
amounts are determined.
(C) If a taxpayer's financial accounting year ends five or more
months after the end of its taxable year, the taxpayer computes AFS
revenue for the taxable year based on the AFS revenue reported on the
AFS prepared for the financial accounting year ending within the
taxpayer's taxable year. For this paragraph (h)(4)(i)(C), if a taxpayer
uses a 52-53 week year for financial accounting or Federal income tax
purposes, the last day of such year shall be deemed to occur on the
last day of the calendar month ending closest to the end of such year.
(ii) Examples. The following examples illustrate the principles of
paragraph (j)(4) of this section.
(A) Example 1: Interim closing of the books. A is a calendar year
taxpayer. For its AFS, A's financial results are reported on a June 30
fiscal year. Using the method described in paragraph (h)(4)(i)(A) of
this section, for the taxable year 2021, A uses the financial results
reported on its June 30, 2021 AFS to determine whether an item of gross
income is treated as ``taken into account as AFS revenue'' from January
1, 2021, through June 30, 2021, and uses financial data and accounting
procedures from its June 30, 2022 AFS to prepare an interim closing of
the books as of December 31, 2021 to determine whether an item of gross
income is treated as ``taken into account as AFS revenue'' from July 1,
2021, through December 31, 2021.
(B) Example 2: Pro rata approach. A is a calendar year taxpayer.
For its AFS, A's financial results are reported on a June 30 fiscal
year. Using the method described in paragraph (h)(4)(i)(B) of this
section, for the taxable year 2021, A computes AFS revenue for the 2021
tax year by taking the AFS revenue for the financial accounting year
ending June 30, 2021 and multiplying it by a ratio equal to the number
of days in the financial accounting year that are part of the 2021 tax
year/365 and then adding to that amount the AFS revenue for the
financial accounting year ending June 30, 2022 multiplied by the number
of days in the financial accounting year that are part of the 2021 tax
year/365.
(C) Example 3: AFS revenue for the taxable year based on AFS ending
in taxpayer's taxable year. The same facts as in paragraph
(h)(4)(ii)(B) of this section (Example 2) apply, except that A uses the
method described in paragraph (h)(4)(i)(C) of this section. For the
taxable year 2021, A uses the financial results reported on its June
30, 2021 AFS to determine whether an item of gross income is treated as
``taken into account as AFS revenue'' as of the end of its 2021 taxable
year. Accordingly, any AFS revenue reported on the taxpayer's June 30,
2022 AFS is disregarded when determining whether an item of gross
income is treated as ``taken into account as AFS revenue'' as of the
end of the 2021 taxable year.
(i) [Reserved]
(j) Special ordering rule for certain items of income for debt
instruments--(1) In general. If an item of income, or portion thereof,
with respect to a debt instrument is described in paragraph (j)(2) of
this section, the rules of this section apply before the rules in
sections 1271 through 1275 and Sec. Sec. 1.1271-1 through 1.1275-7
(OID rules). Therefore, an item of income, or portion thereof,
described in paragraph (j)(2) of this section may not be included in
income later than when that item, or portion thereof, is treated as
taken into account as AFS revenue, as determined under paragraph (b)(2)
of this section, regardless of whether the timing of income inclusion
for that item is
[[Page 851]]
normally determined using a special method of accounting. See also
Sec. 1.1275-2(l) for the treatment of the items described in paragraph
(j)(2) of this section under the OID rules.
(2) Specified fees. Paragraph (j)(1) of this section applies to
fees (specified fees) that are not spread over a period of time as
discount or as an adjustment to the yield of a debt instrument (such as
points) in the taxpayer's AFS and, but for paragraph (j) of this
section and Sec. 1.1275-2(l), would be treated as creating or
increasing OID for Federal income tax purposes. For example, the
following specified fees (specified credit card fees) are described in
this paragraph (j)(2):
(i) A payment of additional interest or a similar charge provided
with respect to amounts that are not paid when due on a credit card
account (for example, credit card late fees);
(ii) Amounts charged under a credit card agreement when the
cardholder uses the credit card to conduct a cash advance transaction
(for example, credit card cash advance fees); and
(iii) Amounts a credit or debit card issuer is entitled to upon a
purchase of goods or services by one of its cardholders (for example,
interchange fees, which are sometimes labeled merchant discount in
certain private label credit card transactions).
(3) Example. C, a credit card issuer, is a calendar-year accrual
method taxpayer with a calendar year AFS. In 2021, a cardholder uses
C's credit card to purchase $100 of merchandise from a merchant and the
cardholder earns a reward of 1% of the purchase price of $100 ($1) as
part of C's cardholder loyalty program. Upon purchase, C becomes
entitled to an interchange fee equal to 2% of the purchase price of
$100 ($2). For its AFS, C reports the $2 of interchange fees as AFS
revenue for 2021. C's $2 of interchange fees is described in paragraph
(j)(2)(iii) of this section. Under paragraph (j)(1) of this section, C
must apply the rules in this section before applying the OID rules. See
also Sec. 1.1275-2(l). Therefore, C's $2 of interchange fees is
included in gross income in 2021, the year it is treated as ``taken
into account as AFS revenue.'' Under paragraph (b)(2)(i)(A) of this
section, the $2 of interchange revenue is not reduced by the $1 reward.
Even if C reports interchange fees net of rewards in its AFS for 2021
($2 of interchange fee minus $1 reward liability), under paragraph
(b)(2)(i)(A) of this section, C includes $2 of interchange revenue in
gross income in 2021. See sections 162 and 461(h) for the treatment of
the reward by C.
(k) Treatment of adjustments to deferred revenue in an AFS--(1) In
general. If a taxpayer treats an item of gross income as deferred
revenue in its AFS and writes down or adjusts that item, or portion
thereof, to an equity account (for example, retained earnings) or
otherwise writes down or adjusts that item of deferred revenue in a
subsequent taxable year, AFS revenue for that subsequent taxable year
is increased or decreased, as applicable by the amount of that item, or
portion thereof, that is written down or adjusted. See Sec. 1.451-
8(c)(5).
(2) Example--(i) Facts. D, a remanufacturer of industrial
equipment, is a calendar-year, accrual method taxpayer with a calendar
year AFS. On January 1, 2021, D enters into a contract with a customer
and receives a payment of $100x to remanufacture equipment in 2021 and
2022. The contract is not a long-term contract under section 460. For
its AFS 2021, D performs remanufacturing services and reports $40x of
the $100x payment as AFS revenue for 2021, and treats $60x of the $100x
payment as deferred revenue.
(ii) Facts for taxable year 2022. On January 1, 2022, all of the
stock of D is acquired by an unrelated third party and D adjusts
deferred AFS revenue to $50x (the expected cost to provide the
services) by charging $10x ($60x-$50x = $10x) to retained earnings. In
addition, for 2022, D performs remanufacturing services and reports
$50x of the deferred revenue as AFS revenue.
(iii) Analysis for taxable year 2022. Under paragraph (k)(1) of
this section, D's $10x write down to deferred revenue for 2022 is
treated as ``taken into account as AFS revenue'' for 2022.
(l) Methods of accounting--(1) In general. Except as otherwise
provided in this section, a change to comply with this section is a
change in method of accounting to which the provisions of sections 446
and 481 and the regulations in this part under sections 446 and 481 of
the Code apply. A taxpayer seeking to change to a method of accounting
permitted in this section must secure the consent of the Commissioner
in accordance with Sec. 1.446-1(e) and follow the administrative
procedures issued under Sec. 1.446-1(e)(3)(ii) for obtaining the
Commissioner's consent to change its accounting method. For example,
the use of the AFS income inclusion rule under paragraph (b)(1) of this
section under which the taxpayer determines the amount of the item of
gross income that is treated as ``taken into account as AFS revenue''
by making the adjustments provided in paragraph (b)(2)(i) of this
section, the use of the AFS income inclusion rule under paragraph
(b)(1) of this section under which the taxpayer determines the amount
of the item of gross income that is treated as ``taken into account as
AFS revenue'' by making only the adjustments provided in paragraph
(b)(2)(ii) of this section (the alternative AFS revenue method), the
AFS cost offset method under paragraph (c) of this section, the use of
a method of determining AFS revenue under paragraph (i)(4) of this
section, are methods of accounting under section 446 and the
regulations in this part under section 446 of the Code. In addition, a
change in the manner of recognizing revenue in an AFS that changes or
could change the timing of the inclusion of income for Federal income
tax purposes is generally a change in method of accounting under
section 446 and the regulations in this part under section 446 of the
Code. However, a change resulting from the restatement of AFS revenue
may not always constitute a change in method of accounting under
section 446 and the regulations in this part under section 446 of the
Code. For example, a restatement of AFS revenue to correct an error
described in Sec. 1.446-1(e)(2)(ii)(b) does not constitute a change in
method of accounting under section 446.
(2) Transition rule for changes in method of accounting--(i) In
general. Except as provided in paragraph (l)(2)(ii) of this section, a
taxpayer that makes a qualified change in method of accounting for the
taxpayer's first taxable year beginning after December 31, 2017, is
treated as making a change in method of accounting initiated by the
taxpayer under section 481(a)(2). A taxpayer obtains the consent of the
Commissioner to make the change in method of accounting by using the
applicable administrative procedures that govern changes in method of
accounting under section 446(e). See Sec. 1.446-1(e)(3).
(ii) Special rules for OID and specified credit card fees. The
rules of paragraph (l)(2)(i) of this section apply to a qualified
change in method of accounting for the taxpayer's first taxable year
beginning after December 31, 2018, if the change relates to a specified
credit card fee as defined in paragraph (j)(2) of this section. For
paragraph (l) of this section, the section 481(a) adjustment period for
any adjustment under section 481(a) for a change in method of
accounting described in the preceding sentence is six taxable years.
[[Page 852]]
(iii) Qualified change in method of accounting. For paragraph
(l)(2) of this section, a qualified change in method of accounting
means any change in method of accounting that is required by section
13221 of Public Law 115-97, 131 Stat. 2054 (2017) (TCJA), or was
prohibited under the Internal Revenue Code of 1986 prior to TCJA
section 13221 and is now permitted as a result of TCJA section 13221.
(m) Applicability date--(1) In general. Except as provided in
paragraph (m)(2) of this section, this section applies for taxable
years beginning on or after January 1, 2021.
(2) Delayed application with respect to certain fees.
Notwithstanding paragraph (m)(1) of this section, paragraph (j) of this
section applies to specified fees (as defined in paragraph (j)(2) of
this section) that are not specified credit card fees (as defined in
paragraph (j)(2) of this section) for taxable years beginning on or
after January 6, 2022.
(3) Early application of this section--(i) In general. Except as
provided in paragraph (m)(3)(ii) of this section, taxpayers and their
related parties, within the meaning of sections 267(b) and 707(b), may
apply both the rules in this section and, to the extent relevant, the
rules in Sec. 1.451-8, in their entirety and in a consistent manner,
to a taxable year beginning after December 31, 2017, and before January
1, 2021, provided that, once applied to a taxable year, the rules in
this section and, to the extent relevant, the rules in Sec. 1.451-8,
are applied in their entirety and in a consistent manner to all
subsequent taxable years. See section 7508(b)(7) and Sec. 1.451-8(h).
(ii) Certain fees--(A) Specified credit card fees. In the case of
specified credit card fees, a taxpayer and its related parties, within
the meaning of sections 267(b) and 707(b), may apply both the rules in
this section and the rules in Sec. 1.1275-2(l), in their entirety and
in a consistent manner, to a taxable year beginning after December 31,
2018, and before January 1, 2021, provided that, once applied to a
taxable year, the rules in this section and Sec. 1.1275-2(l) that
apply to specified credit card fees are applied in their entirety and
in a consistent manner to all subsequent taxable years (other than the
rules applicable to specified fees that are not specified credit card
fees). See section 7508(b)(7) and Sec. 1.1275-2(l)(2).
(B) Specified fees. Paragraphs (m)(3)(i) and (m)(3)(ii)(A) of this
section do not apply to specified fees that are not specified credit
card fees.
0
Par. 6. Section 1.451-8 is added to read as follows:
Sec. 1.451-8 Advance payments for goods, services, and certain other
items.
(a) Definitions. Except as otherwise provided in this section, the
following definitions apply for this section:
(1) Advance payment--(i) In general. An advance payment is a
payment received by a taxpayer if:
(A) The full inclusion of the payment in the gross income of the
taxpayer for the taxable year of receipt is a permissible method of
accounting, without regard to this section;
(B) Any portion of the payment is taken into account as AFS revenue
for a subsequent taxable year, or, if the taxpayer does not have an
applicable financial statement any portion of the payment is earned by
the taxpayer in a subsequent taxable year. To determine the amount of
the payment that is treated as ``taken into account as AFS revenue,''
the taxpayer must adjust AFS revenue for any amounts described in Sec.
1.451-3(b)(2)(i)(A), (C), and (D);
(C) The payment is for:
(1) Services;
(2) The sale of goods;
(3) The use, including by license or lease, of intellectual
property, including copyrights, patents, trademarks, service marks,
trade names, and similar intangible property rights, such as franchise
rights and arena naming rights;
(4) The occupancy or use of property if the occupancy or use is
ancillary to the provision of services, for example, advance payments
for the use of rooms or other quarters in a hotel, booth space at a
trade show, campsite space at a mobile home park, and recreational or
banquet facilities, or other uses of property, so long as the use is
ancillary to the provision of services to the property user;
(5) The sale, lease, or license of computer software;
(6) Guaranty or warranty contracts ancillary to an item or items
described in paragraph (a)(1)(i)(C)(1), (2), (3), (4), or (5) of this
section;
(7) Subscriptions in tangible or intangible format. Subscriptions
for which an election under section 455 is in effect is not included in
this paragraph (a)(1)(i)(C)(7);
(8) Memberships in an organization. Memberships for which an
election under section 456 is in effect are not included in this
paragraph (a)(1)(i)(C)(8);
(9) An eligible gift card sale;
(10) Any other payment identified by the Secretary of the Treasury
or his delegate (Secretary) under section 451(c)(4)(A)(iii), including
in guidance published in the Internal Revenue Bulletin (see Sec.
601.601(d)(2) of this chapter); or
(11) Any combination of items described in paragraphs
(a)(1)(i)(C)(1) through (10) of this section.
(ii) Exclusions from the definition of advance payment. An advance
payment does not include:
(A) Rent, except for amounts paid for an item or items described in
paragraph (a)(1)(i)(C)(3), (4), or (5) of this section;
(B) Insurance premiums, to the extent the inclusion of those
premiums is governed by Subchapter L of the Internal Revenue Code;
(C) Payments with respect to financial instruments (for example,
debt instruments, deposits, letters of credit, notional principal
contracts, options, forward contracts, futures contracts, foreign
currency contracts, credit card agreements (including rewards or
loyalty points under such agreements), financial derivatives, or
similar items), including purported prepayments of interest;
(D) Payments with respect to service warranty contracts for which
the taxpayer uses the accounting method provided in Revenue Procedure
97-38, 1997-2 C.B. 479 (see Sec. 601.601(d)(2) of this chapter);
(E) Payments with respect to warranty and guaranty contracts under
which a third party is the primary obligor;
(F) Payments subject to section 871(a), 881, 1441, or 1442;
(G) Payments in property to which section 83 applies;
(H) Payments received in a taxable year earlier than the taxable
year immediately preceding the taxable year of the contractual delivery
date for a specified good (specified good exception) unless the
taxpayer uses the method under paragraph (f) of this section;
(I) Any other payment identified by the Secretary under section
451(c)(4)(B)(vii), including in guidance published in the Internal
Revenue Bulletin (see Sec. 601.601(d)(2) of this chapter); and
(J) Any combination of items described in paragraphs (a)(1)(ii)(A)
through (I) of this section.
(2) Advance payment income inclusion amount. The term advance
payment income inclusion amount means the amount of the advance payment
that is required to be included in gross income for the taxable year
under the applicable rules in this section.
(3) Advance payment inventory inclusion amount. The term advance
payment inventory inclusion amount means the amount of the advance
payment from the sale of an item of
[[Page 853]]
inventory that, but for the cost of goods in progress offset, would be
includable in gross income under paragraph (b), (c), or (d) of this
section, as applicable, for the taxable year.
(4) AFS revenue. The term AFS revenue has the same meaning as
provided in Sec. 1.451-3(a)(4).
(5) Applicable financial statement. The term applicable financial
statement (AFS) has the same meaning as provided in Sec. 1.451-
3(a)(5).
(6) Contractual delivery date. The term contractual delivery date
means the month and year of delivery listed in the original written
contract to the transaction entered into between the parties prior to
initial receipt of any payments.
(7) Cost of goods. The term cost of goods means the costs that are
properly capitalized and included in inventory under sections 471 and
263A or any other applicable provision of the Internal Revenue Code and
that are allocable to an item of inventory for which an advance payment
inventory inclusion amount is calculated. See paragraph (e)(6) of this
section for specific rules for a taxpayer using the simplified methods
under section 263A.
(8) Cost of goods in progress offset. The term cost of goods in
progress offset has the meaning provided in paragraph (e)(4) of this
section.
(9) Cumulative cost of goods in progress offset. The term
cumulative cost of goods in progress offset means the cumulative cost
of goods in progress offset amounts under paragraph (e) of this section
for a specific item of inventory that have reduced an advance payment
inventory inclusion amount attributable to such item of inventory in
prior taxable years.
(10) Eligible gift card sale. The term eligible gift card sale
means the sale of a gift card or gift certificate if:
(i) The taxpayer is primarily liable to the customer, or holder of
the gift card, for the value of the card until redemption or
expiration; and
(ii) The gift card is redeemable by the taxpayer or by any other
entity that is legally obligated to the taxpayer to accept the gift
card from a customer as payment for items listed in paragraphs
(a)(1)(i)(C)(1) through (11) of this section.
(11) Enforceable right. The term enforceable right has the same
meaning as provided in Sec. 1.451-3(a)(9).
(12) Performance obligation. The term performance obligation has
the same meaning as provided in Sec. 1.451-3(a)(11).
(13) Prior income inclusion amounts. The term prior income
inclusion amounts means the amount of an item of gross income that was
included in the taxpayer's gross income under this section or Sec.
1.451-3 in a prior taxable year.
(14) Received. An item of gross income is received by the taxpayer
if it is actually or constructively received, or if it is due and
payable to the taxpayer.
(15) Specified good. The term specified good means a good for
which:
(i) During the taxable year a payment is received, the taxpayer
does not have on hand, or available to it in such year through its
normal source of supply, goods of a substantially similar kind and in a
sufficient quantity to satisfy the contract to transfer the good to the
customer; and
(ii) All the revenue from the sale of the good is recognized in the
taxpayer's AFS in the year of delivery.
(16) Transaction price. The term transaction price has the same
meaning as provided in Sec. 1.451-3(a)(14).
(b) In general. Except as provided in paragraph (c) or (d) of this
section, an accrual method taxpayer shall include an advance payment in
gross income no later than in the taxable year in which the taxpayer
receives the advance payment.
(c) Deferral method for taxpayers with an applicable financial
statement (AFS)--(1) In general. An accrual method taxpayer with an AFS
that receives an advance payment may elect the deferral method
described in this paragraph (c) if the taxpayer can determine the
extent to which the advance payment is taken into account as AFS
revenue as of the end of the taxable year of receipt and, if
applicable, a short taxable year described in paragraph (c)(6) of this
section. Except as otherwise provided in this section, a taxpayer that
uses the deferral method described in this paragraph (c) must:
(i) Include the advance payment, or any portion thereof, in gross
income in the taxable year of receipt to the extent taken into account
as AFS revenue as of the end of such taxable year, as determined under
paragraph (c)(2) of this section; and
(ii) Include the remaining portion of such advance payment in gross
income in the taxable year following the taxable year in which such
payment is received (next succeeding year).
(2) Adjustments to AFS revenue. The amount of an advance payment
that is treated as ``taken into account as AFS revenue'' as of the end
of the taxable year of receipt under paragraph (c)(1)(i) of this
section is determined by adjusting AFS revenue by amounts described in
Sec. 1.451-3(b)(2)(i)(A), (C), and (D), as applicable.
(3) Examples. The following examples demonstrate the rules in
paragraphs (c)(1) and (2) of this section.
(i) Example 1: Gift cards not eligible for deferral method. E, a
hair styling salon, receives advance payments for gift cards that may
later be redeemed at the salon for hair styling services or hair care
products at the face value of the gift card. The gift cards may not be
redeemed for cash and have no expiration date. E does not track the
sale date of the gift cards and includes advance payments for gift
cards in AFS revenue when redeemed. Because E is unable to determine
the extent to which advance payments are taken into account as AFS
revenue for the taxable year of receipt, E cannot use the deferral
method for these advance payments.
(ii) Example 2: Gift cards eligible for deferral method. The same
facts as in paragraph (c)(3)(i) of this section (Example 1) apply,
except that the gift cards have an expiration date 12 months from the
date of sale, E does not accept expired gift cards, and E includes
unredeemed gift cards in AFS revenue for the taxable year in which the
cards expire. Because E tracks the sale date and the expiration date of
the gift cards for its AFS, E can determine the extent to which advance
payments are taken into account as AFS revenue for the taxable year of
receipt. Therefore, E meets the requirement of paragraph (c)(1) of this
section and may elect the deferral method for these advance payments.
(4) Acceleration of advance payments--(i) In general. A taxpayer
that uses the deferral method described in this paragraph (c) must
include in gross income for the taxable year, all advance payments not
previously included in gross income:
(A) If, in that taxable year, the taxpayer either dies or ceases to
exist in a transaction other than a transaction to which section 381(a)
applies; or
(B) If, and to the extent that, in that taxable year, the
taxpayer's obligation for the advance payments is satisfied or
otherwise ends other than in:
(1) A transaction to which section 381(a) applies; or
(2) A section 351(a) transfer that is part of a section 351
transaction in which:
(i) Substantially all assets of the trade or business, including
advance payments, are transferred;
(ii) The transferee adopts or uses the deferral method in the year
of transfer; and
(iii) The transferee and the transferor are members of the same
consolidated group, as defined in Sec. 1.1502-1(h).
[[Page 854]]
(ii) Examples. The following examples illustrate the rules in
paragraph (c)(4) of this section. In each of the following examples,
the taxpayer is a C corporation, uses an accrual method of accounting
for Federal income tax purposes and files its returns on a calendar
year basis. In addition, the taxpayer has an AFS and uses the deferral
method in paragraph (c) of this section.
(A) Example 1: Ceasing to exist. A is in the business of selling
and licensing off the shelf, fully customized, and semi-customized
computer software and providing customer support. On July 1, 2021, A
enters into a 2-year software maintenance contract and receives an
advance payment. Under the contract, A will provide software updates if
it develops an update within the contract period, as well as online and
telephone customer support. A ceases to exist on December 1, 2021, in a
transaction that does not involve a section 351(a) transfer described
in paragraph (c)(4)(i)(B)(2) of this section and is not a transaction
to which section 381(a) applies. For Federal income tax purposes, A
must include the entire advance payment in gross income in its 2021
taxable year.
(B) Example 2: Satisfaction of obligation--(1) Facts. On November
1, 2021, J, a travel agent, receives payment from a customer for an
airline flight that will take place in April 2022. J purchases and
delivers the airline ticket to the customer on November 14, 2021. J
retains the excess of the customer's payment over the cost of the
airline ticket as its commission. The customer may cancel the flight
and receive a refund from J only to the extent the airline itself
provides refunds. In its AFS, J includes its commission in revenue for
2022.
(2) Analysis. The payment for commission income is an advance
payment. Because J is not required to provide any services after the
ticket is delivered to the customer on November 14, 2021, J satisfies
its obligation to the customer for its commission when the airline
ticket is delivered. Thus, for Federal income tax purposes, J must
include the commission in gross income for 2021.
(5) Financial statement adjustments--(i) In general. If a taxpayer
treats an advance payment as an item of deferred revenue in its AFS and
writes-down or adjusts that item, or portion thereof, to an equity
account such as retained earnings, or otherwise writes-down or adjusts
that item of deferred revenue in a subsequent taxable year, AFS revenue
for that subsequent taxable year is increased or decreased, as
applicable, by the amount that is written down or adjusted. See Sec.
1.451-3(k).
(ii) Examples. The following examples illustrate the rules in
paragraph (c)(5) of this section. In each of the following examples,
the taxpayer is a C corporation, uses an accrual method of accounting
for Federal income tax purposes and files its returns on a calendar
year basis. In addition, the taxpayer has an AFS and uses the deferral
method in paragraph (c) of this section.
(A) Example 1--(1) Facts. On May 1, 2021, A received $100 as an
advance payment for a 2-year contract to provide services. For
financial accounting purposes, A recorded $100 as a deferred revenue
liability in its AFS, expecting to report \1/4\ ($25) of the advance
payment in AFS revenue for 2021, \1/2\ ($50) for 2022, and \1/4\ ($25)
for 2023. On August 31, 2021, C, an unrelated corporation that files
its Federal income tax return on a calendar year basis and that is a
member of a consolidated group, acquired all of the stock of A, and A
joined C's consolidated group. A's short taxable year ended on August
31, 2021, and, as of that date, A had included \1/4\ ($25) of the
advance payment in AFS revenue. On September 1, 2021, after the stock
acquisition, and in accordance with purchase accounting rules, C wrote
down A's deferred revenue liability to its fair value of $10 as of the
date of the acquisition. The $10 is included in revenue on A's AFS in
accordance with the method of accounting A uses for financial
accounting purposes.
(2) Analysis. For Federal income tax purposes, A must take \1/4\
($25) of the advance payment into income for its short taxable year
ending August 31, 2021 and must include the remainder of the advance
payment ($75) ($65 write down + $10 future financial statement revenue)
in income for its next succeeding taxable year.
(B) Example 2--(1) Facts. On May 1, 2021, B received $100 as an
advance payment for a contract to be performed in 2021, 2022, and 2023.
On August 31, 2021, D, a corporation that is not a member of a
consolidated group for Federal income tax purposes, acquired all of the
stock of B. Before the stock acquisition, for 2021, B included $40 of
the advance payment in AFS revenue, and $60 as a deferred revenue
liability. On September 1, 2021, after the stock acquisition and in
accordance with purchase accounting rules, B, at D's direction, wrote
down its $60 deferred revenue liability to $10 (its fair value) as of
the date of the acquisition. After the acquisition, B does not take
into account as AFS revenue any of the $10 deferred revenue liability
in its 2021 AFS. B does include $5 in revenue in 2022, and $5 in
revenue in 2023.
(2) Analysis. For Federal income tax purposes, B must include $40
of the advance payment into income in 2021 and must include the
remainder of the advance payment ($60) ($50 write down plus $10 future
financial statement revenue) in income for the 2022 taxable year.
(6) Short taxable year rule--(i) In general. If the taxpayer's next
succeeding taxable year is a short taxable year, other than a taxable
year in which the taxpayer dies or ceases to exist in a transaction
other than a transaction to which section 381(a) applies, and the short
taxable year consists of 92 days or less, a taxpayer using the deferral
method must include the portion of the advance payment not included in
the taxable year of receipt in gross income for the short taxable year
to the extent taken into account as AFS revenue as of the end of such
taxable year, as determined under paragraph (c)(2) of this section. Any
amount of the advance payment not included in gross income in the
taxable year of receipt or the short taxable year, must be included in
gross income for the taxable year immediately following the short
taxable year.
(ii) Example 1--(A) Facts. A is a calendar year taxpayer and is in
the business of selling and licensing off the shelf, fully customized,
and semi-customized computer software and providing customer support.
On July 1, 2021, A enters into a 2-year software maintenance contract
and receives an advance payment of $240 under the contract. Under the
contract, A will provide software updates if it develops an update
within the contract period, as well as provides online and telephone
customer support. A changes its taxable period to a fiscal year ending
March 31. As a result, A has a short taxable year beginning January 1,
2022, and ending March 31, 2022. In its AFS, A includes 6/24 ($60) of
the payment in revenue for the taxable year ending December 31, 2021 to
account for the six-month period July 1 through December 31, 2021; 3/24
($30) in revenue for the short taxable year ending March 31, 2022 to
account for the three-month period January 1 through March 31, 2022;
12/24 ($120) in revenue for the taxable year ending March 31, 2023; and
3/24 ($30) in revenue for the taxable year ending March 31, 2024.
(B) Analysis. Because the taxable year ending March 31, 2021, is 92
days or less, A must include 6/24 ($60) of the payment in gross income
for the taxable year ending December 31, 2021, 3/24 ($30) in gross
income for the short
[[Page 855]]
taxable year ending March 31, 2022, and 15/24 ($150), the remaining
amount, in gross income for the taxable year ending March 31, 2023.
(iii) Example 2--(A) Facts. On May 1, 2021, B received $100 as an
advance payment for a contract to be performed in 2021, 2022, and 2023.
On October 31, 2021, C, an unrelated corporation that files its federal
income tax return on a calendar year basis and that is a member of a
consolidated group, acquired all the stock of B and B joined C's
consolidated group. Before the stock acquisition, for 2021, B included
$40 of the advance payment in AFS revenue, and $60 as a deferred
revenue liability. On November 1, 2021, after the stock acquisition and
in accordance with purchase accounting rules, C wrote down B's $60
deferred revenue liability to $10 (its fair value) as of the date of
the acquisition. After the acquisition, B does not include in revenue
any of the $10 deferred revenue liability in its 2021 AFS. B includes
$5 in revenue in 2022, and $5 in revenue in 2023.
(B) Analysis. For Federal income tax purposes, B must take $40 of
the advance payment into income in its short tax year ending October
31, 2021. B's subsequent tax year, the short tax year ending December
31, 2021, is a tax year that is 92 days or less. Therefore, under
paragraph (c)(6)(i) of this section, B generally will include the
portion of the advance payment not included in the taxable year of
receipt in gross income for this short taxable year to the extent taken
into account as AFS revenue. Although for AFS purposes, no amount is
recognized in revenue for the short period beginning November 1, 2021
and ending on December 31, 2021, under paragraph (c)(5)(i) of this
section, B must treat the amount of the write-down as AFS revenue in
the taxable year in which the write-down occurs. Therefore, B must
include $50 of the advance payment into income in the short tax year
ending December 31, 2021 (equal to the $50 write down plus $0
recognized in B's AFS for the period beginning on November 1, 2021 and
ending December 31, 2021), and must include the remainder of the
advance payment ($10) in income for the 2022 taxable year.
(7) Financial statement conformity requirement. A taxpayer that
uses an AFS to apply the rules under Sec. 1.451-3 must use the same
AFS and, if applicable, the same method of accounting under Sec.
1.451-3(h)(4), to apply the deferral method in paragraph (c) of this
section. Additionally, the AFS rules under Sec. 1.451-3(h) also apply
for purposes of this section.
(8) Contracts with multiple performance obligations--(i) General
rule. If a taxpayer is using the deferral method under this paragraph
(c) and the taxpayer's contract with a customer has more than one
performance obligation, then any payments received under the contract
are allocated to the corresponding item of gross income in the same
manner as such payments are allocated to the performance obligations in
the taxpayer's AFS.
(ii) Example: Computer software subscription with multiple
performance obligations--(A) Facts. P is in the business of licensing
off the shelf, fully customized, and semi-customized computer software
and providing customer support. P uses an accrual method of accounting
for Federal income tax purposes, files its returns on a calendar year
basis, and has an AFS. On July 1, 2021, P receives an advance payment
of $100 for a 2-year software subscription comprised of:
(1)(i) A 1-year ``software maintenance contract'' under which P
will provide software updates within the contract period; and
(ii) A ``customer support agreement'' for online and telephone
customer support.
(2) P reflects the software maintenance contract and the customer
support agreement as two separate performance obligations in its AFS
and allocates $80 of the payment to the software maintenance contract
and $20 to the customer support agreement. P includes the $80 allocable
to the software maintenance payment in AFS revenue as follows: \1/4\
($20) in AFS revenue for 2021; \1/2\ ($40) in AFS revenue for 2022; and
the remaining \1/4\ ($20) in AFS revenue for 2023. Regarding the $20
allocable to the customer support payment, P includes \1/2\ ($10) in
AFS revenue for 2021, and the remaining \1/2\ ($10) in AFS revenue for
2022 regardless of when P provides the customer support.
(B) Analysis. Since the software maintenance contract and the
customer support agreement are two separate performance obligations,
each yielding a separate item of gross income, paragraph (c)(8) of this
section requires P to allocate the $100 payment to each item of gross
income in the same manner as the payment is allocated to each
performance obligation in P's AFS. For Federal income tax purposes, P
must include $30 in gross income for 2021 ($20 allocable to the
software maintenance contract and $10 allocable to the customer support
agreement) and the remaining $70 is included in gross income for 2022.
(iii) Contracts with advance payments that include items subject to
a special method of accounting--(A) In general. The portion of the
payment allocable to the items of gross income described in paragraph
(a)(1)(i)(C) of this section from a contract that includes one or more
items of gross income subject to a special method of accounting and one
or more items of gross income described in paragraph (a)(1)(i)(C) of
this section must be determined based on objective criteria.
(B) Allocation deemed to be based on objective criteria. A
taxpayer's allocation method is based on objective criteria if an
allocation of the payment to each item of gross income is in proportion
to the amounts determined in Sec. 1.451-3(d)(5) or as otherwise
provided in guidance published in the Internal Revenue Bulletin (see
Sec. 601.601(d) of this chapter).
(iv) Example--(A) Facts. B is a calendar-year accrual method
taxpayer with an AFS. In 2020, B enters into a $100x contract to
design, build, operate and maintain a toll road and receives an up-
front payment of $100x. The contract meets the definition of a long-
term contract under Sec. 1.460-1(b)(1). B properly determines that the
obligations to design and build the toll road are long-term contract
activities under Sec. 1.460-1(d)(1) and accounts for the gross income
from these activities under section 460. In addition, B properly
determines that the obligations to operate and maintain the toll road
are non-long-term contract activities under Sec. 1.460-1(d)(2) and
that the gross income attributable to these activities is accounted for
under section 451(b). B allocates $60x of the transaction price amount
to the long-term contract activities and the remaining $40x to the non-
long-term contract activity pursuant to Sec. 1.451-3(d)(5). For AFS
purposes, B allocates $55x of the transaction price amount to the
performance obligations that are long-term contract activities and $45x
to the non-long-term contract activities. B uses the deferral method of
accounting.
(B) Analysis. For Federal income tax purposes, a method of
accounting under section 460 is a special method of accounting under
paragraph (c)(8)(iv) of this section. Pursuant to paragraph (c)(8)(iv)
of this section, B must allocate the payment among the item(s) of gross
income that are subject to section 460 and the item(s) of gross income
described in paragraph (a)(1)(i)(C) of this section based on objective
criteria. B's allocation is deemed to be based on objective criteria if
it allocates the payment in proportion to the amounts determined under
Sec. 1.451-3(d)(5). That
[[Page 856]]
is, $60x to the items of gross income subject to section 460 and $40x
to the items of gross income described in paragraph (a)(1)(i)(C) of
this section.
(9) Special rule relating to eligible gift card sales. For
paragraphs (a)(1)(i)(B) and (c)(1) of this section, if an eligible gift
card is redeemable by an entity described in paragraph (a)(10)(ii) of
this section whose financial results are not included in the taxpayer's
AFS, a payment will be treated as included by the taxpayer in its AFS
revenue to the extent the gift card is redeemed by such entity during
the taxable year.
(10) Examples. The following examples illustrate the rules of
paragraph (c) of this section. In each of the following examples, the
taxpayer uses an accrual method of accounting for Federal income tax
purposes and files its returns on a calendar year basis. In addition,
the taxpayer in each example has an AFS and uses the deferral method
under paragraph (c) of this section. Further, the taxpayer does not use
the advance payment cost offset method in paragraph (e) of this
section.
(i) Example 1: Services. On November 1, 2021, A, in the business of
giving dancing lessons, receives an advance payment of $480 for a 1-
year contract commencing on that date and providing for up to 48
individual, 1-hour lessons. A provides eight lessons in 2021 and
another 35 lessons in 2022. A takes into account \1/6\ ($80) of the
payment as AFS revenue for 2021, and \5/6\ ($400) of the payment as AFS
revenue for 2022. For Federal income tax purposes, under the deferral
method in paragraph (c) of this section, A must include \1/6\ ($80) of
the payment in gross income for 2021, and the remaining \5/6\ ($400) of
the payment in gross income for 2022.
(ii) Example 2: Services. The same facts as in paragraph (c)(10)(i)
of this section (Example 1) apply. A receives an advance payment of
$960 for a 3-year contract under which A provides up to 96 lessons. A
provides eight lessons in 2021, 48 lessons in 2022, and 40 lessons in
2023. A takes into account 1/12 ($80) of the payment as AFS revenue for
2021, \1/2\ ($480) of the payment as AFS revenue for 2022, and 5/12
($400) of the payment as AFS revenue for 2023. For Federal income tax
purposes, under the deferral method in paragraph (c) of this section, A
must include 1/12 ($80) of the payment in gross income for 2021, and
the remaining 11/12 ($880) of the payment in gross income for 2022.
(iii) Example 3: Services. On June 1, 2021, B, a landscape
architecture firm, receives an advance payment of $100 for landscape
services that, under the terms of the agreement, must be provided by
December 2022. On December 31, 2021, B estimates that \3/4\ of the work
under the agreement has been completed. B takes into account \3/4\
($75) of the payment as AFS revenue for 2021, and \1/4\ ($25) of the
payment as AFS revenue for 2022. For Federal income tax purposes, under
the deferral method in paragraph (c) of this section, B must include
\3/4\ ($75) of the payment in gross income for 2021, and the remaining
\1/4\ ($25) of the payment in gross income for 2022, regardless of
whether B completes the job in 2022.
(iv) Example 4: Repair contracts. On July 1, 2021, C, in the
business of selling and repairing television sets, receives an advance
payment of $100 for a 2-year contract under which C agrees to repair
the customer's television set. C takes into account \1/4\ ($25) of the
payment as AFS revenue for 2021, \1/2\ ($50) of the payment as AFS
revenue for 2022, and \1/4\ ($25) of the payment as AFS revenue for
2023. For Federal income tax purposes, under the deferral method in
paragraph (c) of this section, C must include \1/4\ ($25) of the
payment in gross income for 2021 and the remaining \3/4\ ($75) of the
payment in gross income for 2022.
(v) Example 5: Online website design. On July 20, 2021, D, a
website designer, receives an online payment of $75 to design a website
for Customer to be completed on February 1, 2023. D designs and
completes Customer's website on February 1, 2023. D takes into account
the $75 payment for Customer's website as AFS revenue for 2023. The $75
payment D receives for Customer's website is an advance payment. For
Federal income tax purposes, under the deferral method in paragraph (c)
of this section, D must include the $75 payment for the website in
gross income for 2022.
(vi) Example 6: Online subscriptions. G is in the business of
compiling and providing business information for a particular industry
in an online format accessible over the internet. On September 1, 2021,
G receives an advance payment from a subscriber for 1 year of access to
its online database, beginning on that date. G takes into account \1/3\
of the payment as AFS revenue for 2021 and the remaining \2/3\ as AFS
revenue for 2022. For Federal income tax purposes, under the deferral
method in paragraph (c) of this section, G must include \1/3\ of the
payment in gross income for 2021 and the remaining \2/3\ of the payment
in gross income for 2022.
(vii) Example 7: Membership fees. On December 1, 2021, H, in the
business of operating a chain of ``shopping club'' retail stores,
receives advance payments for membership fees. The membership fees are
not prepaid dues income subject to section 456. Upon payment of the
fee, a member is allowed access for a 1-year period to H's stores,
which offer discounted merchandise and services. H takes into account
1/12 of the payment as AFS revenue for 2021 and 11/12 of the payment as
AFS revenue for 2022. For Federal income tax purposes, under the
deferral method in paragraph (c) of this section, H must include 1/12
of the payment in gross income for 2021, and the remaining 11/12 of the
payment in gross income for 2022.
(viii) Example 8: Cruise. In 2021, I, in the business of operating
tours, receives $20x payments from customers for a 10-day cruise that
will take place in April 2022. Under the agreement, I charters a cruise
ship, hires a crew and a tour guide, and arranges for entertainment and
shore trips for the customers. I takes into account the $20x payments
as AFS revenue for 2022. For Federal income tax purposes, I must
include the $20x payments in gross income for 2022.
(ix) Example 9: Broadcasting rights--(A) Facts. K, a professional
sports franchise, is a member of a sports league that enters into
contracts with television networks for the right to broadcast games to
be played between teams in the league. The league entered into a 2-year
broadcasting contract beginning October 1, 2021. K receives two
payments of $100x on October 1 of each contract year, beginning in
2021. K estimates that for each contract year, 25% of the broadcasting
rights are transferred by December 31 of the year of payment, and the
remaining 75% of the broadcasting rights are transferred in the
following year. K takes into account \1/4\ ($25x) of the first
installment payment as AFS revenue for 2021 and \3/4\ ($75x) as AFS
revenue for 2022. K takes into account \1/4\ ($25x) of the second
payment as AFS revenue for 2022 and \3/4\ ($75x) as AFS revenue for
2023.
(B) Analysis. Each installment payment is an advance payment under
paragraph (a)(1) of this section because a portion of each payment is
included in AFS revenue for a subsequent taxable year and the payment
relates to the use of intellectual property. For Federal income tax
purposes, under the deferral method in paragraph (c) of this section, K
must include \1/4\ ($25x) of the first $100x installment payment in
gross income for 2021 and \3/4\ ($75x) of the first installment payment
in gross income for 2022. In addition, K must include \1/4\ ($25x) of
the second $100x payment in gross income for 2022 and \3/4\ ($75x) of
the second installment payment in gross income for 2023.
[[Page 857]]
(x) Example 10: Insurance claims administration--(A) Facts. L is in
the business of negotiating, placing, and servicing insurance coverage
and administering claims for insurance companies. On December 1, 2021,
L enters into a contract with an insurance company to provide property
and casualty claims administration services for a 4-year period
beginning January 1, 2022. Pursuant to the contract, the insurance
company makes four equal annual payments to L; each payment relates to
a year of service and is made during the month prior to the service
year. Since L does not perform any services related to the payment
prior to the service year, L does not meet the requirements of Sec.
1.451-1(a) for the payment prior to the service year. For example, L is
paid on December 1, 2021, for the service year beginning January 1,
2022. L takes into account the first payment as AFS revenue for 2022;
the second payment as AFS revenue for 2023; the third payment as AFS
revenue for 2024; and the fourth payment as AFS revenue for 2025.
(B) Analysis. Each annual payment is an advance payment under
paragraph (a)(1) of this section because each payment is taken into
account as AFS revenue for a subsequent taxable year and the payment
relates to services. For Federal income tax purposes, under the
deferral method in paragraph (c) of this section, L must include: The
first payment in gross income for 2022; the second payment in gross
income for 2023; the third payment in gross income for 2024; and the
fourth payment in gross income for 2025.
(xi) Example 11: internet services--(A) Facts. M is a cable
internet service provider that enters into contracts with subscribers
to provide internet services for a monthly fee that is paid prior to
the service month. For those subscribers who do not own a compatible
modem, M provides a rental cable modem for an additional monthly
charge, that is also paid prior to the service month. Pursuant to the
contract, M will replace or repair the cable modem if it proves
defective during the contract period. In December 2021, M receives
$100x payments from subscribers for January 2022 internet service and
cable modem use. M takes into account the entire $100x payments as AFS
revenue for 2022.
(B) Analysis. For Federal income tax purposes, the $100x payments
are advance payments. Because M uses the deferral method in paragraph
(c) of this section, M must include $100x in gross income for 2022.
(xii) Example 12: License agreement--(A) Facts. On January 1, 2021,
N receives a payment of $250 for entering into a 3-year license
agreement for the use of N's trademark throughout the term of the
agreement. The $250 payment reflects the first year (2021) license fee
of $100 and the third year (2023) license fee of $150. The fee of $125
for the second year is payable on January 1, 2022. N takes into account
$100 of the $250 upfront payment as AFS revenue for 2021, $125 as AFS
revenue for 2022, and $150 of the $250 payment as AFS revenue for 2023.
(B) Analysis. For Federal income tax purposes, N received an
advance payment of $150, the 2023 license fee, in 2021. Because N uses
the deferral method in paragraph (c) of this section, N must defer the
$150 payment and include it in gross income for 2022.
(xiii) Example 13: Computer software subscription with one
performance obligation--(A) Facts. On July 1, 2021, O, in the business
of licensing off the shelf, fully customized, and semi-customized
computer software and providing customer support, receives a payment of
$100 for a 2-year ``software subscription contract'' under which O will
provide software updates if it develops an update within the contract
period, as well as online and telephone customer support. O determines
that its obligations under the software subscription contract are one
performance obligation for financial accounting purposes, which yields
one item of gross income. O takes into account \1/4\ ($25) of the
payment as AFS revenue for 2021, \1/2\ ($50) as AFS revenue for 2022,
and the remaining \1/4\ ($25) as AFS revenue for 2023, regardless of
when O provides updates or customer support.
(B) Analysis. For Federal income tax purposes, the $100 payment is
an advance payment. Because O uses the deferral method in paragraph (c)
of this section, O must include \1/4\ ($25) of the payment in gross
income for 2021 and \3/4\ ($75) in gross income for 2022.
(xiv) Example 14: Gift cards administered by another--(A) General
facts. Q is a corporation that operates department stores and is the
common parent of a consolidated group (the Q group). U, V, and W are
domestic corporations wholly owned by Q and members of the Q group. X
is a foreign corporation wholly owned by Q and not a member of the Q
group. U sells Brand A goods, V sells Brand B goods, X sells Brand C
goods, and Z is an unrelated entity that sells Brand D goods. W
administers a gift card program for the members of the Q group, X, and
Z. Pursuant to the underlying agreements, W issues gift cards that are
redeemable for goods or services offered by U, V, X, and Z. In
addition, U, V, X, and Z sell gift cards to customers on behalf of W
and remit amounts received to W. The agreements provide that W is
primarily liable to the customer for the value of the gift card until
redemption, and U, V, X, and Z are obligated to accept the gift card as
payment for goods or services. When a customer purchases goods or
services with a gift card at U, V, X, or Z, W reimburses that entity
for the sales price of the goods or services purchased with the gift
card, up to the total gift card value.
(B) Facts for taxable year 2021. In 2021, W sells gift cards with a
total value of $900, and, at the end of 2021, the unredeemed balance of
the gift cards is $100. In Q group's AFS, the group includes revenue
from the sale of a gift card when the gift card is redeemed.
Accordingly, of the $900 of gift cards sold in 2021, $800 were redeemed
and taken into account as AFS revenue for 2021. W tracks sales and
redemptions of gift cards electronically, determines the extent to
which advance payments are taken into account as AFS revenue in Q
group's AFS for the taxable year of receipt and meets the requirements
of paragraph (c)(1) of this section.
(C) Analysis. The payments W receives from the sale of gift cards
are advance payments because they are payments for eligible gift cards.
Under the deferral method, W must include $800 of the payments from
gift card sales in gross income in 2021 and the remaining $100 of the
payments in gross income in 2022.
(xv) Example 15: Gift cards of affiliates--(A) Facts. R is a
Subchapter S corporation that operates an affiliated restaurant
corporation and manages other affiliated restaurants. These other
restaurants are owned by other Subchapter S corporations, partnerships,
and limited liability companies. R has a partnership interest or an
equity interest in some of the restaurants. R administers a gift card
program for participating restaurants. Each participating restaurant
operates under a different trade name. Under the gift card program, R
and each of the participating restaurants sell gift cards, which are
issued with R's brand name and are redeemable at all participating
restaurants. Participating restaurants sell the gift cards to customers
and remit the proceeds to R, R is primarily liable to the customer for
the value of the gift card until redemption, and the participating
restaurants are obligated under an agreement with R to accept the gift
card as payment for food, beverages, taxes, and gratuities. When a
customer uses a gift card to make a purchase at a participating
restaurant, R is obligated
[[Page 858]]
to reimburse that restaurant for the amount of the purchase, up to the
total gift card value. In R's AFS, R includes revenue from the sale of
a gift card when a gift card is redeemed at a participating restaurant.
R tracks sales and redemptions of gift cards electronically, is able to
determine the extent to which advance payments are taken into account
as AFS revenue for the taxable year of receipt and meet the
requirements of paragraph (c)(1) of this section.
(B) Analysis. The payments R receives from the sale of gift cards
are advance payments because they are payments for eligible gift card
sales. For Federal income tax purposes, R is eligible to use the
deferral method. Using the deferral method, in the taxable year of
receipt, R must include the advance payment in income to the extent
taken into account as AFS revenue and must include any remaining amount
in income in the taxable year following the taxable year of receipt.
Under paragraph (c)(9) of this section, R is treated as taking into
account revenue from the sale of a gift card as AFS revenue when a gift
card is redeemed at a participating restaurant.
(xvi) Example 16: Gift cards for domestic and international
hotels--(A) Facts. S is a corporation that operates for the benefit of
its franchisee members, who own and operate domestic and international
individual member hotels. S administers a gift card program for its
members by selling gift cards that may be redeemed for hotel rooms and
food or beverages provided by any member hotel. The agreements
underlying the gift card program provide that S is entitled to the
proceeds from the sale of the gift cards, must reimburse the member
hotel for the value of a gift card redeemed, and until redemption
remains primarily liable to the customer for the value of the card. In
S's AFS, S includes payments from the sale of a gift card when the card
is redeemed. S tracks sales and redemptions of gift cards
electronically, determines the extent to which advance payments are
included in AFS revenue for the taxable year of receipt and meets the
requirements of paragraph (c)(1) of this section.
(B) Analysis. The payments S receives from the sale of gift cards
are advance payments because they are payments for eligible gift card
sales. Thus, for Federal income tax purposes, S is eligible to use the
deferral method. Under the deferral method, in the taxable year of
receipt, S must include in income the advance payment to the extent
taken into account as AFS revenue and must include any remaining amount
in income in the taxable year following the taxable year of receipt.
(xvii) Example 17: Discount voucher--(A) Facts. On December 10,
2021, T, in the business of selling home appliances, sells a washing
machine for $500. As part of the sale, T gives the customer a 40%
discount voucher for any future purchases of T's goods up to $100 in
the next 60 days. In its AFS, T treats the discount voucher as a
separate performance obligation and allocates $30 of the $500 sales
price to the discount voucher. T takes into account $12 of the amount
allocated to the discount voucher as AFS revenue for 2021 and includes
$18 of the discount voucher as AFS revenue for 2022.
(B) Analysis. For Federal income tax purposes, the $30 payment
allocated to the discount voucher is an advance payment. Using the
deferral method, T must include the $12 allocable to the discount
voucher in gross income in 2021 and the remaining $18 allocated to the
discount voucher in gross income in 2022.
(xviii) Example 18: Rewards--(A) Facts. On December 31, 2021, U, in
the business of selling consumer electronics, sells a new TV for $1,000
and gives the customer 50 reward points. Each reward point is
redeemable for a $1 discount on any future purchase of U's products.
The reward points are not redeemable for cash and have a 2-year
expiration date. U tracks the issue date, redemption date, and
expiration date of each customer's reward points. Under the terms of
U's reward program, when the customer redeems reward points they are
deemed to use the earliest issued points first. In its AFS, U treats
the rewards points as a separate performance obligation and allocates
$50 of the $1,000 sales price to the rewards points. U is able to
determine the extent to which a payment that is allocated to a reward
point is taken into account in AFS revenue in the year of receipt. U
does not take any of the amount allocated to the reward points into
account as AFS revenue for 2021. U takes into account $25 of the reward
points as AFS revenue for 2022 and $25 of the reward points as AFS
revenue for 2023.
(B) Analysis. For Federal income tax purposes, U's treatment of the
reward points as a separate performance obligation for AFS purposes
yields an item of gross income that must be accounted for separately.
The $50 payment allocated to the reward points item is an advance
payment as the full inclusion of the payment in gross income in the
year of receipt is a permissible method of accounting without regard to
this section, a portion of the payment is taken into account as AFS
revenue in a subsequent taxable year, and the reward points are
redeemable for an item described in paragraph (a)(1)(i)(C) of this
section (goods). Because the entire amount of the $50 advance payment
is taken into account as AFS revenue in tax years following the year of
receipt, U defers the payment and includes the $50 payment in gross
income in 2022.
(xix) Example 19: Credit card rewards--(A) Facts. V issues credit
cards and has a loyalty program under which cardholders earn reward
points when they use V's credit card to make purchases. Each reward
point is redeemable for $1 on any future purchases.
(B) Analysis. Payments under credit card agreements, including
rewards for credit card purchases, are excluded from the definition of
an advance payment under paragraph (a)(1)(ii)(C) of this section.
Accordingly, V cannot use the deferral method for these amounts.
(xx) Example 20: Airline reward miles--(A) Facts. On January 1,
2021, W, a passenger airline company, sells a customer a $700 airline
ticket to fly roundtrip in 2021. As part of the purchase, the customer
receives 7,000 reward points (air miles) from W to be used for future
air travel. The reward points are not redeemable for cash and have a 2-
year expiration date. W tracks the issue date, redemption date, and
expiration date of each customer's reward points. Under the terms of
U's reward program, when the customer redeems reward points they are
deemed to use the earliest issued points first. In its AFS, W treats
the rewards points as a separate performance obligation and allocates
$35 of the $700 ticket price to the reward points. W is able to
determine the extent to which a payment that is allocated to a reward
point is taken into account in AFS revenue in the year of receipt. W
takes into account all $35 as AFS revenue in 2023 when the customer
redeems the air miles.
(B) Analysis. For Federal income tax purposes, W's treatment of the
reward points as a separate performance obligation for AFS purposes
yields an item of gross income that must be accounted for separately.
The $35 allocated to the reward points item is an advance payment as
the full inclusion of the payment in gross income in the taxable year
of receipt is a permissible method of accounting without regard to this
section, a portion of the payment is taken into account as AFS revenue
in a subsequent taxable year, and the reward points are redeemable for
an item described in paragraph (a)(1)(i)(C) of
[[Page 859]]
this section (services). Because the entire amount of the $35 advance
payment is taken into account as AFS revenue in a tax year following
the year of receipt, W defers the payment and includes the $35 payment
in gross income in 2022.
(xxi) Example 21: Chargebacks--(A) Facts. In 2021, X, a
manufacturer of pharmaceuticals, enters into a contract to sell 1,000
units to W, a wholesaler, for $10 per unit, totaling $10,000 (1,000 x
$10 = $10,000). The contract also provides that X will credit W $4 per
unit (chargeback) for sales W makes to qualifying customers. X delivers
600 units to W on December 31, 2021, and bills W $6,000 under the
contract. X anticipates that all of W's sales will be to qualifying
customers and subject to chargeback. For AFS purposes, X adjusts its
2021 AFS revenue of $6,000 by $2,400, the anticipated chargebacks, and
reports $3,600 of AFS revenue.
(B) Analysis. For Federal income tax purposes, under paragraph
(a)(1)(i)(B) of this section, for a payment to qualify as an advance
payment, a portion of the payment must be taken into account as AFS
revenue for a subsequent taxable year. Under paragraph (a)(1)(i)(B) of
this section, the amount of the payment included in AFS revenue for a
subsequent taxable year is $0, calculated as the $6,000 payment reduced
by $6,000 that is treated as taken into account as AFS revenue for 2021
($3,600 of AFS revenue for 2021 + $2,400 of anticipated chargebacks
(section 461 liabilities) which had reduced AFS revenue for 2021).
Because no portion of the $6,000 is taken into account as AFS revenue
in a subsequent taxable year (that is, on an AFS after 2021), the
$6,000 payment received in 2021 is not an advance payment under
paragraph (a)(1)(i) of this section.
(d) Deferral method for taxpayers without an AFS (non-AFS deferral
method)--(1) In general. Only a taxpayer described in paragraph (d)(2)
of this section may elect to use the non-AFS deferral method of
accounting described in paragraph (d)(4) of this section.
(2) Taxpayers eligible to use the non-AFS deferral method. A
taxpayer is eligible to use the non-AFS deferral method if the taxpayer
does not have an applicable financial statement and can determine the
extent to which advance payments are earned in the taxable year of
receipt and, if applicable, a short taxable year described in paragraph
(d)(6) of this section. The determination whether the advance payment
is earned in the taxable year of receipt, or a short taxable year
described in paragraph (d)(6) of this section, if applicable, is
determined on an item by item basis.
(3) Deferral of advance payments based on when payment is earned--
(i) In general. Except as otherwise provided in this section, a
taxpayer that uses the non-AFS deferral method of accounting includes
the advance payment in gross income for the taxable year of receipt to
the extent that it is earned in that taxable year and includes the
remaining portion of the advance payment in gross income in the next
succeeding taxable year.
(ii) When payment is earned. Under the non-AFS deferral method, a
payment is earned when the all events test described in Sec. 1.451-
1(a) is met, without regard to when the amount is received, as defined
under paragraph (a)(14) of this section, by the taxpayer. If a taxpayer
is unable to determine the extent to which a payment is earned in the
taxable year of receipt, or a short taxable year described in paragraph
(d)(6) of this section, if applicable, the taxpayer may calculate the
amount:
(A) On a statistical basis if adequate data are available to the
taxpayer;
(B) On a straight-line basis over the term of the agreement if the
taxpayer receives the advance payment under a fixed term agreement and
if it is reasonable to anticipate at the end of the taxable year of
receipt that the advance payment will be earned ratably over the term
of the agreement; or
(C) Using any other method that may be provided in guidance
published in the Internal Revenue Bulletin (see Sec. 601.601(d) of
this chapter).
(4) Contracts with multiple items of gross income--(i) In general.
If a taxpayer receives a payment that is attributable to one or more
items described in paragraph (a)(1)(i)(C) of this section, the taxpayer
must determine the portion of the payment that is allocable to such
item(s) by using an allocation method that is based on objective
criteria.
(ii) Objective criteria. A taxpayer's allocation method for a
payment described in paragraph (d)(4)(i) of this section is deemed to
be based on objective criteria if the allocation method is based on
payments the taxpayer receives for an item or items it regularly sells
or provides separately or any method that may be provided in guidance
published in the Internal Revenue Bulletin (see Sec. 601.601(d) of
this chapter).
(5) Acceleration of advance payments. The acceleration rules in
paragraph (c)(4) of this section also apply to a taxpayer that uses the
non-AFS deferral method under paragraph (d) of this section.
(6) Short taxable year rule. If the taxpayer's next succeeding
taxable year is a short taxable year, other than a taxable year in
which the taxpayer dies or ceases to exist in a transaction other than
a transaction to which section 381(a) applies, and the short taxable
year consists of 92 days or less, a taxpayer using the non-AFS deferral
method must include the portion of the advance payment not included in
the taxable year of receipt in gross income for the short taxable year
to the extent earned in such taxable year. Any amount of the advance
payment not included in gross income in the taxable year of receipt, or
the short taxable year, must be included in gross income for the
taxable year immediately following the short taxable year.
(7) Eligible gift card sale. For paragraphs (a)(1)(i)(B) and (d)(3)
of this section, if an eligible gift card is redeemable by an entity
described in paragraph (a)(10)(ii) of this section, including an entity
whose financial results are not included in the taxpayer's financial
statement, a payment will be treated as earned by the taxpayer to the
extent the gift card is redeemed by such entity during the taxable
year.
(8) Examples. The following examples illustrate the rules of
paragraph (d) of this section. In the examples in this paragaph (d)(8),
the taxpayer is a calendar year taxpayer that uses the non-AFS deferral
method described in paragraph (d) of this section. None of the taxable
years are short taxable years.
(i) Example 1--(A) Facts. A, a video arcade operator, receives
payments in 2021 for tokens that customers use to play A's arcade
games. The tokens cannot be redeemed for cash, are imprinted with the
name of the arcade, but are not individually marked for identification.
A completed a study on a statistical basis, based on adequate data
available to A, and concluded that for payments received in 2021, 70%
of tokens are expected to be used in 2021, 20% of tokens are expected
to be used in 2022, and 10% of tokens are expected to never be used.
Based on the study, under paragraph (d)(3)(ii)(A) of this section, A
determines that 80% of the advance payments are earned for 2021 (70%
for tokens expected to be used in 2021 plus 10% for tokens that are
expected to never be used).
(B) Analysis. For Federal income tax purposes, A must include 80%
of the advance payments in gross income for 2021 and 20% of the advance
payments in gross income for 2022.
(ii) Example 2--(A) Facts. B is in the business of providing
internet services. On September 1, 2021, B receives an
[[Page 860]]
advance payment from a customer for a 2-year term for access to its
internet services, beginning on that date. B does not have an AFS. B is
unable to determine the extent to which the payment is earned in the
taxable year of receipt. However, at the close of the 2021 taxable
year, it is reasonable for B to anticipate that the advance payment
will be earned ratably over the term of the agreement.
(B) Analysis. For Federal income tax purposes, pursuant to
paragraph (d)(3)(ii)(B) of this section, B determines the extent to
which the payment is earned in tax year 2021 on a straight-line basis
over the term of the agreement and takes that amount into income in
2021. The remaining amount of the advance payment is taken into gross
income in the 2022 taxable year.
(e) Advance payment cost offset method--(1) In general. This
paragraph (e) provides an optional method of accounting for advance
payments from the sale of inventory (advance payment cost offset
method). A taxpayer that chooses to use the advance payment cost offset
method for a trade or business must use the method of accounting for
all advance payments received by that trade or business that meet the
criteria in this paragraph (e). Additionally, a taxpayer that chooses
to use this method for a trade or business and that has an AFS must
also use the AFS cost offset method described in Sec. 1.451-3(c). A
taxpayer that uses the AFS cost offset method and the advance payment
cost offset method to account for gross income, including advance
payments, from the sale of an item of inventory, determines the
corresponding AFS income inclusion amount, as defined in Sec. 1.451-
3(a)(1), and the advance payment income inclusion amount for a taxable
year by following the rules in Sec. 1.451-3(c)(2) rather than the
rules under this paragraph (e). However, if all payments received for
the sale of item of inventory meet the definition of an advance payment
under paragraph (a)(1) of this section, a taxpayer that uses the
advance payment cost offset method determines the corresponding advance
payment income inclusion amount for a taxable year by:
(i) Following the rules in paragraph (e)(2) of this section,
subject to the additional rules and limitations in paragraphs (e)(5)
through (8) of this section, if the taxable year is a taxable year
prior to the taxable year in which ownership of the item of inventory
is transferred to the customer; and
(ii) Following the rules in paragraph (e)(3) of this section,
subject to the additional rules and limitations in paragraphs (e)(5)
through (8) of this section, if the taxable year is the taxable year in
which ownership of the item of inventory is transferred to the
customer.
(2) Determining the advance payment income inclusion amount in a
year prior to the year of sale. To determine the advance payment income
inclusion amount for a taxable year prior to the year in which
ownership of the item of inventory is transferred to the customer, the
taxpayer must first determine the advance payment inventory inclusion
amount for such item for such year. This advance payment inventory
inclusion amount is then reduced by the cost of goods in progress
offset for the taxable year, as determined under paragraphs (e)(4),
(5), and (8) of this section. This net amount is the advance payment
income inclusion amount for the taxable year.
(3) Determining the advance payment income inclusion amount in the
year of sale. The advance payment income inclusion amount for the
taxable year in which ownership of the item of inventory is transferred
to the customer is equal to the portion of any advance payment for such
item that was not required to be included in gross income in a prior
taxable year. This amount is not reduced by a cost of goods in progress
offset under paragraph (e)(4) of this section. However, the taxpayer is
entitled to recover the costs capitalized to the item of inventory as
cost of goods sold in accordance with sections 471 and 263A or any
other applicable provision of the Internal Revenue Code. See Sec.
1.61-3.
(4) Cost of goods in progress offset. The cost of goods in progress
offset for the taxable year is calculated as:
(i) The cost of goods allocable to the item of inventory through
the last day of the taxable year; reduced by
(ii) The cumulative cost of goods in progress offset attributable
to the item of inventory, if any.
(5) Limitations to the cost of goods in progress offset. The cost
of goods in progress offset is determined separately for each item of
inventory. The cost of goods in progress offset attributable to one
item of inventory cannot reduce the advance payment inventory inclusion
amount attributable to a different item of inventory. Further, the cost
of goods in progress offset cannot reduce the advance payment inventory
inclusion amount for the taxable year below zero.
(6) Exception for gift cards. The cost of goods in progress offset
in this paragraph (e) does not apply to eligible gift card sales or
payments received for customer reward points.
(7) Acceleration of advance payments. The acceleration rules in
paragraph (c)(4) of this section also apply to a taxpayer that uses the
advance payment cost offset method under this paragraph (e), regardless
of whether the taxpayer uses such method in connection with the full
inclusion method under paragraph (b) of this section, or the deferral
method under paragraph (c) or (d) of this section. If an advance
payment is subject to the acceleration rules, paragraph (e)(2) of this
section does not apply to determine the advance payment income
inclusion amount for the taxable year described in paragraph (c)(4) of
this section. Further, a taxpayer that uses the advance payment cost
offset method under this paragraph (e) applies paragraph
(c)(4)(i)(B)(2)(ii) of this section by substituting ``same advance
payment method as the transferor'' for ``deferral method.''
(8) Inventory costs for the advance payment cost offset method--(i)
Inventory costs not affected by cost of goods in progress offset. The
cost of goods comprising the cost of goods in progress offset does not
reduce the costs that are capitalized to the items of inventory
produced or items of inventory acquired for resale by the taxpayer.
While the cost of goods in progress offset reduces the amount of the
advance payment inventory inclusion amount, the cost of goods in
progress offset does not affect how and when costs are capitalized to
inventory under sections 471 and 263A or any other applicable provision
of the Internal Revenue Code or when those capitalized costs will be
recovered.
(ii) Consistency between inventory methods and advance payment cost
offset method. The costs of goods comprising the cost of goods in
progress offset must be determined by applying the taxpayer's methods
of accounting for inventory for Federal income tax purposes. A taxpayer
using the advance payment cost offset method must calculate its cost of
goods in progress offset by reference to all costs that the taxpayer
has permissibly capitalized and allocated to items of inventory under
its methods of accounting for inventory for Federal income tax
purposes, but including no more costs than what the taxpayer has
permissibly capitalized and allocated to items of inventory.
(iii) Allocation of ``additional section 263A costs'' for taxpayers
using simplified methods. If a taxpayer uses the simplified production
method as defined under Sec. 1.263A-2(b), the modified simplified
production method as defined under Sec. 1.263A-2(c), or the simplified
resale method as defined under Sec. 1.263A-3(d) to determine the
amount of its ``additional section 263A
[[Page 861]]
costs,'' as defined under Sec. 1.263A-1(d)(3), to be included in
ending inventory, then solely for computing the cost of goods in
progress offset, the taxpayer must determine the portion of additional
section 263A costs allocable to an item of inventory by multiplying its
total additional section 263A costs accounted for under the simplified
method for all items of inventory subject to the simplified method by
the following ratio:
Section 471 costs allocable to the specific item of inventory
------------------------------------------------------------------------
Total section 471 costs for all items of inventory subject to the
simplified method
(9) Additional procedural guidance. The IRS may publish procedural
guidance in the Internal Revenue Bulletin (see Sec. 601.601(d) of this
chapter) that provides alternative procedures for complying with the
rules under this paragraph (e), including alternative methods of
accounting for cost offsets.
(10) Examples. The following examples illustrate the rules of
paragraph (e) of this section. In each of the following examples, the
taxpayer is a C corporation, has an AFS, uses an accrual method of
accounting for Federal income tax purposes, and uses a calendar year
for Federal income tax purposes and AFS purposes. In addition, in each
example, the taxpayer uses the deferral method and the advance payment
cost offset method under paragraph (e) of this section. Lastly, the
taxpayer does not produce unique items, as described in Sec. 1.460-
2(a)(1) and (b), or any item that normally requires more than 12
calendar months to complete, as determined under Sec. 1.460-2(a)(2)
and (c). Any production period that exceeds 12 calendar months is due
to unforeseen production delays.
(i) Example 1--(A) Facts. In December 2021, A enters into a
contract with Customer to manufacture and deliver a good in 2024, with
a total contract price of $100x. The costs to produce the good are
required to be capitalized under sections 471 and 263A as the good is
inventory in the hands of A. On the same day, A receives a payment of
$40x from the customer. For its AFS, A reports all of the revenue from
the sale of the good as AFS revenue in the year of delivery, which is
also the year in which ownership of the good transfers from A to
Customer. As of December 31, 2021, A has not incurred any cost to
manufacture the good. The payment of $40x does not satisfy the
specified good exception in paragraph (a)(1)(ii)(H) of this section,
and thus qualifies as an advance payment. During 2022, A does not
receive any additional payments on the contract and incurs $10x of
costs to manufacture the good. A properly capitalizes and allocates
such costs to the manufactured good under sections 471 and 263A.
(B) Analysis. Because no portion of the $40x advance payment is
taken into account as AFS revenue as of the end of 2021, A is not
required to include any portion of the advance payment in gross income
for 2021. For 2022, A's advance payment inventory inclusion amount is
$40x, which is the amount of the advance payment that, but for the cost
of goods in progress offset, would be includable in gross income in
2022 under the deferral method. Pursuant to paragraph (e)(2) of this
section, A reduces such amount by the $10x cost of goods in progress
offset, determined as the costs of goods through the end of 2022 ($0
costs incurred in 2021 plus 10x of costs incurred in 2022 = $10x). A is
required to include this net amount of $30x in gross income in 2022.
The remaining portion of the payment ($10x) is deferred and included in
gross income in 2024, the taxable year in which ownership of the good
is transferred to Customer.
(ii) Example 2--(A) Facts. The same facts as in paragraph
(e)(10)(i) of this section (Example 1) apply. In addition, in 2023, A
incurs costs of $20x to manufacture the good but does not receive any
additional payments from Customer.
(B) Analysis. A includes $0 in gross income in 2023. A's cost of
goods in progress offset for 2023 is $20x under paragraph (e)(4) of
this section ($30x costs of goods through the last day of 2023 ($10x
for 2022 plus $20x for 2023 = $30x) less $10x cumulative cost of goods
in progress offset amounts taken in prior taxable years). However,
because A's advance payment inventory inclusion amount for 2023 is $0,
which is the amount of the advance payment that, but for the cost of
goods in progress offset, would be includable in gross income in 2023
under the deferral method, paragraph (e)(5) of this section limits the
cost offset to $0.
(iii) Example 3--(A) Facts. The same facts as in paragraph
(e)(10)(i) of this section (Example 1) apply, except that in taxable
year 2022, A incurs additional costs of $25x to manufacture the good,
resulting in total costs of $35x to manufacture the good in taxable
year 2022.
(B) Analysis. For 2022, A's advance payment inventory inclusion
amount is $40x, which is the amount of the advance payment that, but
for the cost of goods in progress offset, would be includable in gross
income in 2022 under the deferral method. Pursuant to paragraph (e)(2)
of this section A reduces such amount by the $35x cost of goods in
progress offset, determined as the costs of goods through the end of
2022 ($0 costs incurred in 2021 plus $35x costs incurred in 2022 =
$35x). A is required to include this net amount of $5x in gross income
in 2022. The remaining portion of the payment ($35x) is deferred and
included in gross income in 2024, the taxable year in which ownership
of the good is transferred to the customer.
(iv) Example 4--(A) Facts. The same facts as in paragraph
(e)(10)(iii) of this section (Example 3) apply, except that for tax
year 2023, A receives an additional advance payment of $60x, and does
not incur any costs to manufacture the good in 2023. In 2024, A incurs
the remaining $10x to manufacture the good, and delivers the good to
Customer.
(B) Analysis for 2023. Because no portion of the $60x advance
payment is taken into account as AFS revenue as of the end of 2023, A
is not required to include any portion of the $60x advance payment in
gross income for 2023.
(C) Analysis for 2024. In 2024, the ownership of the good is
transferred to Customer. Accordingly, pursuant to paragraph (e)(3) of
this section, A is required to include $95x, the remaining portion of
all advance payments that were not required to be included in gross
income in a prior taxable year ($100x of total advance payments
received less $5x that was required to be included in gross income in
2022). Although A does not reduce such amount by a cost offset, it
reduces gross income in 2024 by recovering the $45x of costs
capitalized to inventory as cost of goods sold ($35x costs incurred in
2022 plus $10x costs incurred in 2024) in accordance with sections 471
and 263A. Accordingly, A's gross income for 2024 is $50x.
(f) Method treating payments qualifying for the specified goods
exception as advance payments--(1) In general. A taxpayer may choose to
use the specified good section 451(c)
[[Page 862]]
method to treat all payments that qualify for the specified goods
exception in paragraph (a)(1)(ii)(H) of this section as advance
payments that are eligible to be accounted for under this section.
Under the specified good section 451(c) method, an advance payment is a
payment received by the taxpayer in a taxable year earlier than the
taxable year immediately preceding the taxable year of the contractual
delivery date for a specified good. A taxpayer that chooses to use the
specified good section 451(c) method for a trade or business must apply
this method of accounting for all advance payments that meet the
criteria described in paragraph (a)(1)(ii)(H) of this section.
(2) Example: Method for the specified goods exception to not apply.
On May 1, 2021, A, a corporation that files its Federal income tax
return on the calendar year basis, receives a prepayment for $100x, for
a contract to manufacture and deliver a good in September of 2023. All
of the revenue from the sale of the good is recognized in A's AFS in
the year of delivery. During 2021, A does not have on hand, or
available to it in such year through its normal source of supply, goods
of a substantially similar kind and in a sufficient quantity to satisfy
the contract to transfer the good to the customer. The payment of $100x
satisfies the specified good exception. A uses the method under
paragraph (f) of this section to treat all payments that otherwise
satisfy the specified good exception as advance payments under this
section. For Federal income tax purposes, A must treat the payment of
$100x as an advance payment and account for such payment under the full
inclusion method in paragraph (b) of this section, or the deferral
method in paragraph (c) of this section, as applicable. Additionally,
the taxpayer may choose to apply the advance payment cost offset method
in paragraph (e) of this section.
(g) Election and methods of accounting--(1) Procedures for making
election under section 451(c)(1)(B). An election to apply the deferral
method under section 451(c)(1)(B) is made by the taxpayer filing a
Federal income tax return reflecting the deferral method in computing
its taxable income. If the application of the deferral method under
section 451(c)(1)(B) results in the taxpayer changing its method of
accounting, the election may only be made by the taxpayer complying
with the method change procedures under this paragraph (g).
(2) Methods of accounting. A change to comply with this section is
a change in method of accounting to which the provisions of sections
446 and 481 and the regulations in this part under sections 446 and 481
of the Code apply. A taxpayer seeking to change to a method of
accounting permitted in this section must secure the consent of the
Commissioner in accordance with Sec. 1.446-1(e) and follow the
administrative procedures issued under Sec. 1.446-1(e)(3)(ii) for
obtaining the Commissioner's consent to change its accounting method.
For example, use of the full inclusion method under paragraph (b) of
this section, the AFS deferral method under paragraph (c) of this
section, the non-AFS deferral method under paragraph (d) of this
section, the advance payment cost offset method under paragraph (e) of
this section, and the specified good section 451(c) method under
paragraph (f) of this section are adoptions of, or changes in, a method
of accounting under section 446 of the Internal Revenue Code or the
regulations in this part under section 446 of the Code. In addition, a
change in the manner of recognizing advance payments in revenue in an
AFS that changes or could change the timing of the inclusion of income
for Federal income tax purposes is a change in method of accounting
under section 446 and the regulations in this part under section 446 of
the Code.
(h) Applicability date--(1) In general. The rules of this section
apply to taxable years beginning on or after January 1, 2021.
(2) Early application. Taxpayers and their related parties, within
the meaning of sections 267(b) and 707(b), may apply both the rules in
this section and, to the extent relevant, the rules in Sec. 1.451-3,
in their entirety and in a consistent manner, to a taxable year
beginning after December 31, 2017, and before January 1, 2021, provided
that, once applied to a taxable year, the rules in this section and, to
the extent relevant, the rules in Sec. 1.451-3, are applied in their
entirety and in a consistent manner to all subsequent taxable years.
See section 7805(b)(7) and Sec. 1.451-3(m).
0
Par. 7. Section 1.1271-0 is amended by adding entries for Sec. 1.1275-
2(l) and (l)(1) and (2) to read as follows:
Sec. 1.1271-0 Original issue discount; effective date; table of
contents.
* * * * *
Sec. 1.1275-2 Special rules relating to debt instruments.
* * * * *
(l) OID rule for income item subject to section 451(b).
(1) In general.
(2) Applicability dates.
* * * * *
0
Par. 8. Section 1.1275-2 is amended by adding paragraph (l) to read as
follows:
Sec. 1.1275-2 Special rules relating to debt instruments.
* * * * *
(l) OID rule for income item subject to section 451(b)--(1) In
general. Notwithstanding any other rule in sections 1271 through 1275
and Sec. Sec. 1.1271-1 through 1.1275-7, if, and to the extent, a
taxpayer's item of income with respect to a debt instrument is subject
to the timing rules in Sec. 1.451-3 because the item of income is a
specified fee described in Sec. 1.451-3(j) (such as credit card late
fees, credit card cash advance fees, or interchange fees), then the
taxpayer does not take the item into account to determine whether the
debt instrument has any OID. As a result, the taxpayer does not treat
the item as creating or increasing any OID on the debt instrument.
(2) Applicability dates--(i) In general. Except as provided in
paragraph (l)(2)(ii) and (iii) of this section, for a specified credit
card fee as defined in Sec. 1.451-3(j)(2), paragraph (l)(1) of this
section applies for taxable years beginning on or after January 1,
2021, and, for a specified fee that is not a specified credit card fee,
paragraph (l)(1) of this section applies for taxable years beginning on
or after January 6, 2022.
(ii) Early application. For a taxable year beginning after December
31, 2018, and before January 1, 2021, a taxpayer and its related
parties, within the meaning of sections 267(b) and 707(b), may choose
to apply both paragraph (l)(1) of this section and the rules in Sec.
1.451-3, in their entirety and in a consistent manner, to all specified
credit card fees subject to Sec. 1.451-3, provided that once applied
to a taxable year the rules in paragraph (l)(1) of this section and the
rules in Sec. 1.451-3 that apply to specified credit card fees, are
applied in their entirety and in a consistent manner for all subsequent
taxable years. See section 7508(b)(7).
[[Page 863]]
(iii) Applicability date for accounting method changes. Paragraph
(l)(1) of this section will not apply in applying section 13221(e) of
Public Law 115-97, 131 Stat. 2054 (2017), to determine the section
481(a) adjustment period for any adjustment under section 481(a) for a
qualified change in method of accounting required under section 451(b)
and Sec. 1.451-3 for a specified credit card fee.
Sunita Lough,
Deputy Commissioner for Services and Enforcement.
Approved: December 14, 2020.
David J. Kautter,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2020-28653 Filed 12-30-20; 4:15 pm]
BILLING CODE 4830-01-P